Labor productivity, measured as the industry-standardized ratio of sales to number of employees, has an ability to predict average stock returns. In the portfolio sort, firms with high labor productivity earn higher expected returns than those with low productivity. The difference in returns is unexplained by the risk-adjusted asset pricing models. In the cross-section, labor productivity remains as a significant predictor of stock returns after adjusting for size, book-to-market, momentum, asset growth, and profitability.

We examine the cross-sectional relation between the ratio of log growth in physical capital to log growth in labor and subsequent stock returns. The ratio is a negative predictor of abnormal returns and the relation strengthens with measures of financing constraint while remaining robust to previously provided determinants of returns. A ratio-based 2-factor model outperforms common asset pricing models explaining various anomalies indicating that anomalies reflect cross-sectional variation in growth ratio. We interpret the findings as outcomes reflecting displacements on the production isoquant, and show the pattern in returns is consistent with an investment-based model in which firms face financing constraints.

We examine the cross-sectional relation between log growth in physical capital to log growth in labor and subsequent stock returns. The ratio is a strong predictor of negative future abnormal returns. This relation strengthens with measures of financing constraint while remaining robust to previously provided determinants of returns. A ratio-based 2-factor model outperforms common models explaining various asset pricing anomalies, indicating that anomalies reflect cross-sectional variation in this ratio. We interpret the findings as outcomes reflecting displacements on the production isoquant, and show an investment-based asset pricing model with financing constraint generates the aforementioned pattern in returns.

This paper documents a robust new fact about the cross section of stock returns: stocks of companies with higher past production efficiency earn significantly higher average returns in the future. The return difference between the high production efficiency and the low production efficiency portfolio is 25.7% annually, after adjusted for exposures to the market return, size, value and momentum factor. The production efficiency retains its forecasting capability even on large capitalization stocks, and the abnormal return associated with the production efficiency is the strongest within small capitalization stocks. The predicting power of the production efficiency is more persistent for large capitalization stocks than for small capitalization stocks. The empirical finding casts doubt on the measures that use the firm's productivity as one of the determinants to assess the firm's financial constraint.

Solutions to the equity premium puzzle should inform us about the cross-section of stock returns. An external habit model with heterogeneous firms reproduces numerous stylized facts about both the equity premium and the value premium. The equity premium is large, time-varying, and linked with consumption volatility. The cross-section of expected returns is log-linear in B/M, and the slope matches the data. The explanation for the value pre-mium lies in the interaction between the cross-section of cash flows and the time-varying risk premium. Value firms are temporarily low produc-tivity firms, which will eventually experience high cash flows. The present value of these temporally distant cash flows is sensitive to risk premium movements. The value premium is the reward for bearing this sensitivity. Empirical evidence verifies that value firms have higher cash-flow growth. The data also show that value stock returns are more sensitive to risk premium movements, as measured by consumption volatility shocks.