Desarrollo de las sesiones

In asset pricing studies, firm’s profitability is another type of fundamental information that public can gain to achieve excess returns that seemingly violate the EMH. Inspired by the dividend-discount model, the stock return is determined by the discount of its expected cumulative dividends in each period and, thus, the dividend payment is one of the predictors understanding asset prices, stated by Beaver (1968). Early research like Basu (1977) also tests market efficiency related to firm’s profitability by examining if post- announcement stock return changes are due to market inefficient, which is

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categorised as event study in Fama (1991) research. As for the return predictability tests, Haugen and Baker (1996) find that a firm’s earning-to-price (E/P) ratio, commonly used in accounting research to represent a firm’s profitability, earned positive returns over the S&P 500 index return of about 0.27% per month in the 1979.1 to 1986.6 period, and 0.26% per month in the subsequent 1986.7 to 1993.12 period.

High profitability firms tend to be those that are large or who have a low book- to-market ratio; thus, the researchers argue that a profitability anomaly is unlikely due to the high distress risk, one of the potential explanations to the entire universe of anomalies proposed by Fama and French (1993). However, Fama and French (1996) argue that the pricing power of E/P is driven by a firm’s size and book-to-market ratio, with no statistically significant α_FF3 among E/P sorted decile portfolios. The insignificant FF-3 alpha suggests that profitability has no ongoing pricing power on expected stock returns. Malkiel (2003) further confirms this finding by showing the pricing power of 𝐸/𝑃 is no longer significant to post-1985 U.S. stocks, and presents several plausible explanations based on rational school of thoughts.

Fama and French (2006) bring the profitability factor back to centre stage in terms of asset pricing research. They argue that a firm’s profitability is predictable and, to show this, provide a predictive model where the O-score, a bankruptcy risk factor proposed by Ohlson (1980), is included with statistics significant predicting power. In addition, they also present empirical evidence that a firm’s profitability, measured as positive earnings divided by book value

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of equity, has additional pricing power above and beyond the common risk factors in Fama and French (1996). In light of this, Novy-Marx (2013) dissects the relationship between a firm’s profitability and cross-sectional stock returns and finds that most earning-related anomalies are explainable with the FF-3 model and a zero-cost factor portfolio formed by firm’s gross profitability. Ball et al. (2015) further find that, depending on the deflator of profitability ratio, operating profitability gives higher pricing power than gross profitability and earning to book equity ratio. These two profitability ratios were both significant in the 1963 to 2010 period, an extended time offering a return pattern that is relatively unaffected by extreme events where stock returns are at an anomalous high.

2.5.2 Related theories explaining the pricing power of profitability

The expected cash flow theory suggests that most anomalies exist due to correlation with a firm’s expected earnings, and firm’s profitability is, as argued by Novy-Marx (2013), a “clean” proxy of such. Using a revised dividend discount model, Fama and French (2006) link firm’s expected earnings to book- to-market ratio and expected stock return. They argue that expected earnings are positively related to stock dividends, and this revises their earlier assertation that distress risk is the reason of causing value and size anomaly. The Fama- French 5-factor model has some success with this, according to Fama and French (2015), offering better predictive power than 𝐹𝐹 − 3 or CAPM in terms of cross-sectional stock returns in U.S. domestic and international markets. These research findings incorporate the pricing power of firm’s profitability and recognise it as a pricing factor rather than an anomaly.

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Research on corporate governance has presented robust findings documenting that good corporate governance is related to firms’ profitability and subsequent stock returns. Core et al. (1999) argue that the higher agency problem drives low firm performance, and this is due to failures on the part of the CEO and top managers in creating value-maximising decisions. Gompers et al. (2003) find anti-takeover intensity to be negatively priced in subsequent cross-sectional stock returns, while Giroud and Mueller (2011) further expand the findings of Gompers et al. (2003) by showing that pricing power is industry-related and can, therefore, be better identified by industry-adjusted profitability. This suggests that investors are sophisticated at exploiting corporate governance premium to support equity investing.

The logic that distress risk is liable to anomalies such as firm’s profitability has several rational expressions. Fama and French (1996) propose a plausible theory that investors charge a surplus to hold stocks with high exposure to financial distress. The missing value of human capital, captured by measures of financial distress, therefore represents market anomalies. The correct way to measure human capital is, however, still an unsolved question. Recent studies expand the scale of such research by utilising financial distress to express other emerging anomalies. Agarwal and Taffler (2008) find that in the UK stock market, momentum anomaly represents for distress risk. George and Hwang (2010) and Avramov et al. (2013) use multiple proxies of distress likelihood to examine the predicting power of distress risk among several common anomalies and find a threshold effect driven by distress risk. Most anomalies do not repeatedly emerge in the portfolio of high distress risk businesses. To explain the size

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effect, Kapadia (2011) has created a “tracking” portfolio on underlying aggregate distress risk that can explain average realised gains as well as the Fama-French three-factor model. The highlight of this research is that under the new asset pricing model, the excess return is insignificant, and this suggests that the new model outranks existing accomplishments by being able to explain returns from a rational school perspective.

As proposed by Novy-Marx (2013) and Ball et al. (2015), there is no prior literature examining whether firm’s profitability is explainable by firm characteristics, which leads to a research gap. This is partly because these effects have only been recently identified. Future research could be based on existing accounting literature by considering the other determinants of firm’s profitability, then testing whether firms’ characteristics explain their profitability premiums in terms of cross-sectional stock returns.

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3 RESEARCH METHODOLOGY

3.1Portfolio Analysis