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Dissecting the Profitability Premium

Huijun Wang

University of Delaware

Jianfeng Yu

University of Minnesota

December 2013

AFA 2013 San Diego Meetings Paper

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.

Number of Pages in PDF File: 69

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

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Date posted: November 21, 2010 ; Last revised: February 8, 2015

Suggested Citation

Wang, Huijun and Yu, Jianfeng, Dissecting the Profitability Premium (December 2013). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1711856 or http://dx.doi.org/10.2139/ssrn.1711856

Contact Information

Huijun Wang
University of Delaware ( email )
B & E Finance, UD
306 Purnell Hall
NEWARK, DE Delaware 19716
United States
Jianfeng Yu (Contact Author)
University of Minnesota ( email )
321 19th Avenue
Suite 3-122
Minneapolis, MN 55455
United States
HOME PAGE: http://users.cla.umn.edu/~jianfeng/
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