Digesting the Profitability and Investment Premiums: Evidence from the Short Selling Activity

Abstract

This paper highlights the effects of short selling activity on the profitability and investment premiums. Recently, Fama and French (2015) extend their three-factor asset pricing model by adding profitability and investment factors. Using short interest as a proxy to measure the short selling activity, we find that the stocks without shorting show significant higher profitability premium, while short selling activity has no impact on the investment premium. We also provide evidence that the profitability premium is more likely than the investment premium to be associated with the sentiment-driven mispricing, and short sellers are skilled at eliminating sentiment-driven mispricing. Collectively, our results suggest that the two new Fama-French factors have different underlying attributions. While the profitability premium is more consistent with cash flow-based interpretation, the investment premium is more consistent with risk-based interpretation.

Keywords: Profitability, Investment, Short Selling, Investor Sentiment

JEL Classification: G12, G14