On the Explanations for the Gross Profitability Effect: Insights from International Equity Markets

Abstract

This paper attempts to distinguish between rational and behavioral explanations for the gross profitability effect in the international setting. Using data from 41 countries over the period 1980-2010, we find that in most countries, firms with higher gross profitability subsequently experience higher stock returns. This positive effect of gross profitability on returns is significantly stronger in countries with low investment frictions, such as the U.S. However, the effect is not stronger in countries with severe limits-to-arbitrage, such as China. The results are consistent with the implications of investment-based asset pricing theory and not consistent with the behavioral mispricing explanation.

Keywords: Gross profitability, Cross-sectional returns, International equity markets, Q-theory, Mispricing

JEL Classification: G12, G14, G15