A Cautionary Tale: Profitability Anomalies and Mispricing Associated with Financial Statement Variables

• In Event: Earnings Management and Disclosure

Abstract

We show that limits to arbitrage (especially arbitrage risk) are associated with returns of the gross and cash-based operating profitability anomalies, suggesting mispricing plays a role in their return predictability. In contrast, returns generated from the operating profitability strategy have no relation with barriers to arbitrage and exhibit no evidence of mispricing. We also find SG&A expenses and accruals are subject to mispricing in the cross-section of returns. Additionally, we show that the correlation between SG&A expenses (accruals) and gross (cash-based operating) profitability explains the mispricing effects of the profitability anomaly. Given the differences between the profitability measures are definitional in nature, the evidence suggests researchers should proceed with caution when searching for risk-related profitability measures since correlations with certain accounting variables will reflect mispricing the profitability measure’s hedge portfolio returns.

Authors

• Jared DeLisle, Utah State University

• Zafer Yuksel, University of Massachusetts Boston

• Gulnara R Zaynutdinova, West Virginia University