Changes in firm profitability, heterogeneous investor beliefs, and stock returns

In this study,we show that changes in profitability predict a firm's stock returns and future profitability.We construct three horizon-based profitability changes,including short-,medium-,and long-term changes.We find that the predictive information for short-term changes in profitability is not subsumed by the profitability level in the Chinese stock market.We also find that short-term profitability changes generate an asymmetrical premium across different market states.Furthermore,we find that the beta anomaly is embedded in the premium generated by a short-term change in profitability.In addition,we explore the underlying mechanisms of the profitability premium and propose a heterogeneous investor belief channel to explain the profitability premium.We find that riskbased q-theory also helps explain the profitability premium.Therefore,the profitability premium comes from a mixed source and cannot be entirely explained by a single theory.