Dissecting the Profitability Premium

Abstract

Previous studies show that the profitability-based factor can explain almost all asset pricing anomalies, highlighting the importance of firm profitability. This paper investigates both risk-based and behavioral-based explanations of the profitability premium itself. First, we show that the traditional macro risk is unlikely to be the source of the observed profitability premium. Second, the profitability premium exists primarily among firms with high arbitrage costs or high information uncertainty, and the majority of this premium is derived from the negative alpha of low profitability firms, consistent with the notion that overpricing is more prevalent than underpricing due to greater impediments to short. Third, we investigate the pattern of profitability premium at different holding horizons and find little evidence on long-run reversal, suggesting that the profitability premium is more likely to be related to underreaction, rather than ex-post overreaction. Finally, we compare three leading behavioral theories of over- and underreaction based on their different implications on the profitability premium, and our results suggest that inattention-induced underreaction is most plausible.

Keywords: profitability, anomaly, limit of arbitrage, information uncertainty, underreaction