A Study On Profitability Premium In Chinese Stock Market

In academic field,modern asset pricing theories including CAPM,Black-Scholes Option Pricing Model,and APT Model etc.have been considered as the foundations for stock return prediction,stock valuation and asset allocations.Motivated by voluminous literature on stock market anomalies such as value effect and size effect since 1980 s,Fama and French proposed three-factor model which is considered as the benchmark measuring investment performance.In recent years,profitability has attracted much attention from researchers to capture the cross-sectional variation of stock return(Fama and French,2006,2008;Novy-Marx,2013).Based on the q-theory of investment,Li,Livdan,and Zhang(2009)recently argue that investment and profitability are fundamental forces in the cross section of expected stock return,and Hou,Xue and Zhang(2015a)formally add investment and profitability as asset pricing factors in a new q-theory four-factor model.Similarly,Fama and French(2015)also extend their famous Fama-French three-factor model to a five-factor model by adding investment and profitability factors inspired by valuation theory.These research shows that profitability not only earns high positive premium but also helps to capture most asset pricing anomalies that plague the Fama-French(1993)three-factor model.With the development of asset pricing research,the dimensions of value investing are still expanding consistently.After illustrated in Security Analysis for the first time,regarded as the bible of investment,written by Benjamin Graham and David Dodd,value investing has been developing and practicing for nearly 100 years.Currently,it has been characterized as a sort of mainstream investment philosophy and widely accepted investment style.Issues like screening stocks in high quality,building value strategies with excellent performance in long-run,explaining key drivers in abnormal return are vital research topics with high attentions.Traditional value strategies endeavor to acquire productive capacity cheaply so that investors try their best to buy assets at bargain prices.Strategies based on either of value's dimensions generate significant abnormal returns,but the real benefits of value investing accrue to investors that pay attention to both price and profit.With the development of research on profitability premium,profitability investing exploits another core dimension of value.Given the importance of profitability,however,majority of the studies concentrate on US market,and there is little research investigating profitability's return predictability in the international setting especially in emerging markets like China.China's financial market has gained remarkable attention from the practitioners and academics with rapid expansion in last decade.Chinese stock market has become the second largest among all national stock markets with the market capitalization of $6 trillion by the year of 2014.However,Chinese stock market has long been criticized as speculative and lack of strong link between equity valuation and firms' fundamental information such as profitability.Nevertheless,after experiencing last decade's intense reforms and development,Chinese market's informativeness has increased significantly and the whole market environment has become more mature.With the deepening of China's globalization,China's stock market has become an important part of the global capital market.Thus,it is urgent to explore whether profitability as a key fundamental signal is priced in Chinese market.Chinese market also provides interesting setting for us to test the effectiveness of high profit investing.In the context of Chinese stock market,we explore the relation between profitability and expected stock return in order to examine the performance of profitability-based value investing strategies and seek economic mechanism explaining the investment performance by means of combining qualitative analysis and quantitative analysis.Specifically,there are 8 chapters in this paper which are discussed as follows:Chapter 1,Introduction.It introduces the motivation,purpose,main research contents and significance & innovation of this paper.Chapter 2,Literature review.We investigate the theory evolution of value investing and focus on vital theories of profitability premium.We further to provide comments on the status quo of related academic research at home and abroad.Chapter 3,Theoretical foundation.We analyse the potential theoretical explanations for profitability premium in terms of Q theory,valuation model and mispricing theory.Chapter 4,Data and method.This chapter shows all necessary work for empirical research including data and sample selection,variable definition and summary statistics,as well as specific empirical techniques.Chapter 5-7,Empirical research in this paper.In Chapter 5,we employ various measures to proxy for a firm's profitability and investigates the profitability premium systematically.Furthermore,we verify the robustness of profit investing strategies considering value and size factors in Chapter 6.Finally,we compare the behavioral mispricing versus rational q-theory explanations for profitability effect empirically in Chapter 7.Chapter 8,Conclusion and enlightenment.It concludes the main findings of the whole paper and proposes advices for investors and market mechanism construction.In the end,it provides several prospects based on current research.To summarize,this paper mainly has the following findings and conclusions:First of all,we observe large positive profitability premium in the Chinese market and find that firms with high profitability generate substantially higher future stock returns than those with low profitability.The GPA(ROA,ROE,ROIC)based profitability spread portfolio generates an average abnormal return about 18%(15%,13%,10%)per year with statistical significance at the 1% level based on the Fama-French three-factor model.Moreover,the profitability premium remains strong after controlling for other important determinants of the cross-section of stock returns in the Fama-Macbeth regression analysis.In particular,we compare profitability with firm size,book-to-market,and momentum.We find that the forecasting power of profitability remains significant after including these controls,and it contains highly positive predictive ability for subsequent stock return as shown by the large regression coefficients and t-statistics of regression analysis.In addition,this profitability premium is stronger among firms with large capitalization and high growth indicating that profitability based strategies belong to large growth strategy.By means of Size-Value-Profitability triple sorting system,we could achieve huge abnormal return of about 30% per year over 2001.07–2015.06 sample period.Finally,our empirical evidence suggests that mispricing appears to be not useful in explaining profitability premium.Specifically,employing five standard proxies for valuation uncertainty and limits-to-arbitrage in the literature,we find that the profitability premium,surprisingly,is much stronger among firms that are relatively easier to value and easier to arbitrage.The profitability premium is often insignificant or marginally significant among those firms that have higher information uncertainty and are harder to arbitrage.On the contrary,the rational risk-based q-theory of investment is proved to be able to account for the profitability premium in China.According to the q-theory with investment frictions,expected stock return is equal to the expected marginal benefit of investment divided by current marginal cost of investment.If q-theory is useful in explaining profitability effect,it implies an important conditional pattern: the profitability premium should be stronger among firms with lower investment frictions,since such firms tend to have lower marginal cost of investment,which will amplify the positive relationship between profitability and expected return.Empirically,we use six proxies from the literature to identify investment frictions including the asset size,dividend payout,state ownership,SA index,KZ index,and WW index.Based on the portfolio analysis with independent double sorts on profitability and investment frictions,we find that the profitability premium is substantially higher among firms with less investment frictions which are characterized by state-owned enterprises(SOE)attribute,larger asset size,higher dividend payout ratio,richer cash flow,greater sales growth,and lower debtto-asset ratio,completely consistent with the implications of q-theory.Last but not the least,the innovation of this paper could be summarized into four points:Firstly,sigificant profitability premium has been observed in Chinese market.Due to the reason that Fama-French five-factor models and Q-factor models have both newly come out,few Chinese scholars complete empirical research concentrating on profitability factor,the new asset pricing factor.This research gap could be filled up by this paper which mainly focus on profitability premium in Chinese stock market.Secondly,it expands the dimensions of value investing strategies.We research on the profitability based strategies in depth utilizing newly found proxies.The empirical results provide practical guidance for Chinese value investors building efficient multi-dimensional stock screen and extend the investor's investment opportunity set.Thirdly,profitability is measured comprehensively.We use a variety of profitability proxies in building value investing strategies and show the investment performance in multiple panels so as to provide comprehensive characterization about profitability and ensure the robustness of strategies.Fourthly,the economic explanations for profitability premium have been found.Most of current research about stock market anomalies in China only focus on the strategies performance itself but neglect to study on the underlying mechanism driving such performance.We contribute to differentiate between the behavioral and rational based explanations for profitability premium by exploring China's unique informational and institutional setting.