It has been well-documented that profitability is positively correlated with stock returns. Firms with higher profits earn higher returns. The profitability factor has also been shown to eliminate most of the well-known anomalies that can represent problems for the Fama-French four-factor model (i.e., returns that cannot be explained by exposure to the factors of beta, size, value and momentum). Thus, it has been incorporated into the newer factor models, including both the Fama-French five-factor model and the q-factor model.
Several papers have examined the issue of whether the profitability premium is the result of a risk premium or mispricing. Ryan Liu contributes to the literature on this subject through his November 2015 study, “Profitability Premium: Risk or Mispricing?”, which covered the period July 1963 through 2013.
Profitable Firms Outperform
Consistent with the prior research, Liu found that profitable firms have quite consistently outperformed the unprofitable firms (in 73% of the years in his sample) and have done so with lower return volatility, resulting in a higher Sharpe ratio.
While profitable firms have higher unconditional returns, investors might still avoid them if their returns are the lowest during bad times. Investors often care the most about returns during bad times, when their marginal utility of wealth is high.
However, Liu found that the premium is actually higher during economic downturns. Profitable firms do even better than the unprofitable firms during bad times, which, as we mentioned previously, is when marginal utility (the benefit of incremental income or wealth) is the highest. Thus, profitable companies are less susceptible to negative macroeconomic conditions—the profitability premium increases in recessions and when the stock market is doing poorly.
For example, Liu found that the worst one-year drawdown for the least profitable firms was -74%, nearly 30% worse than that of the most profitable firms. Liu concluded the evidence makes it hard to reconcile the profitability premium with a risk-based explanation, although it is consistent with persistent behavioral errors related to expectations.
A Mispricing Effect?
Liu then turned his attention to the mispricing hypothesis. Specifically, he examined the difference between earnings forecasted by sell-side analysts and actual earnings realized across profitability-sorted portfolios. If the low return of unprofitable firms relative to profitable firms was the result of investors being too optimistic about future performance, the difference between forecasted and actual earnings (the expectation error) should be larger for unprofitable firms.
Liu found a monotonically decreasing relationship across the 10 deciles of profitability from low to high. The expectation error was not only larger for unprofitable firms, it was persistent for up to five years. His investigation of the data led him to conclude investors expect the performance of profitable firms to mean-revert faster than they actually do, and they are willing to bet on the revival of the unprofitable firms despite low net income and poor current performance.
This is somewhat different from the more typical glamour story, in which naive investors become overly optimistic about the stocks in favor at the time because of good news or positive past performance.
But in this case, over-optimism is about the potential for mean-reversion of unprofitable companies, which tend to be newer, smaller firms in distress. Thus, these stocks tend to be overvalued. Due to limits on arbitrage, as well as the costs and risks of shorting, overvaluation is harder to correct than undervaluation.
While Liu found it difficult to reconcile the profitability premium with a risk-based explanation, it’s wholly consistent with the mispricing hypothesis. His findings are entirely consistent with prior research.