The duality of value and mean reversion

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This chapter examines how the value and long-term return reversal or “mean reversion�? strategies are related and what makes them different. Comparing risk-return characteristics in backtests, the authors find that the performance of the value strategy dominates the performance of a mean-reverting strategy. They further establish that relative price-to-book-value (P/B) ratios are strong predictors of mean reversion; thus, they conclude, selling high P/B stocks and buying low P/B stocks is a sound rule for rebalancing a value portfolio. The authors also demonstrate that, unlike security prices, company fundamentals are not mean-reverting. By controlling for objective information about company fundamentals, P/B ratios help distill the mean-reverting component of stock prices reflecting only transitory effects of investors’ trades. The authors infer that the value strategy gains a performance advantage over the mean reversion strategy because it is attuned to a purer signal.

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Portfolio Construction, Measurement, and Efficiency: Essays in Honor of Jack Treynor