Abstract
This paper investigates whether rational risk or behavioral mispricing helps to explain the profitability premium in the Chinese stock market setting. We find that firms with high profitability generate substantially higher future stock returns than those with low profitability in China. This positive effect of profitability on returns is robust after controlling for alternative firm characteristics and risks, and is stronger among firms with large capitalization and high growth. We further show that profitability premium is stronger among firms with low investment frictions, consistent with the implications of investment-based q-theoretical asset pricing models. However, it is not stronger among firms with high limits to arbitrage, not consistent with the behavioral mispricing based explanations.
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