Swedroe: Mispricing Underlies Profitability Premium

June 24, 2016

It has been well-documented that profitability is positively correlated with stock returns—firms with higher profits earn higher returns. The question that we will ask today about the profitability premium relates to its source: Is it based on risk? Or, is it an anomaly that results from persistent pricing errors?

F.Y. Eric Lam, Shujing Wang and K.C. John Wei contribute to the literature with their January 2015 study, “The Profitability Premium: Macroeconomic Risks or Expectation Errors?” Lam, Wang and Wei explored two alternative explanations for the profitability premium—the rational explanation based on macroeconomic risks and the mispricing explanation attributed to expectation errors.

The measures of macroeconomic risks were related to industrial production, inflation, the term premium and default risk. The measure for expectation errors is based on an investment sentiment index that includes the average closed-end fund discount, the number and the first-day returns of IPOs, NYSE turnover, equity share of total new issues and the dividend premium (the natural log of the difference in average market-to-book ratios between dividend-paying stocks and nonpayers).

Study Results
The authors’ study included all publicly traded firms found in the Compustat database with fiscal years falling in the period 1963 to 2010. Using three measures of profitability (return on equity, return on assets and gross profitability), they found:

  • Gross profitability is the strongest predictor of future stock returns among the various profitability measures.
  • The hedge portfolio of buying firms in the highest gross profitability quintile and selling firms in the lowest quintile generates a value-weighted average excess return of 0.31% per month (with a t-statistic of 2.16). The Fama-French three-factor alpha and the Carhart four-factor alpha are 0.55% per month (with a t-statistic of 4.49) and 0.50% per month (with a t-statistic of 4.34), respectively. The equal-weighted average excess return, the Fama-French three-factor alpha and the Carhart four-factor alpha are 0.42% per month (with a t-statistic of 3.05), 0.40% per month (with a t-statistic of 2.99) and 0.35% per month (with a t-statistic of 2.96), respectively.
  • Macroeconomic risks explain only about one-third of the profitability premium.
  • Adding a misvaluation factor based on investor sentiment helps explain a large portion of the profitability premium. The equal-weighted and value-weighted return spreads between high- and low-profitability firms both become insignificant after controlling for the misvaluation factor.
  • The profitability premium only concentrates in firms whose market valuations are inconsistent with profitability and therefore subject to ex-ante expectation errors.
  • Firms with high profitability but low market valuation have significantly higher abnormal earnings announcement returns, analyst earnings forecast errors and forecast revisions than firms with low profitability but high market valuation.
  • The profitability premium only exists during high-sentiment periods for firms with ex-ante expectation errors.
  • The profit of both the long leg and the short leg of the profitability strategy increases significantly with sentiment, suggesting that both undervaluation and overvaluation contribute to the profitability premium.

Conclusion

The authors concluded that their results suggest misvaluation—as well as its subsequent correction—plays an important role in determining the profitability premium. These findings are entirely consistent with those of Huijun Wang and Jianfeng Yu, authors of the December 2013 study “Dissecting the Profitability Premium.”

The fact that we now know pricing errors—more than rational risk-based explanations—contribute to the profitability premium does not mean it’s doomed to disappear. Anomalies can persist because of limits to arbitrage, which prevent mispricings from being corrected. A good example of this is that the momentum premium has persisted for more than 20 years since the publication of the first paper exploring it.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

 

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