Asian

n Journal of F
Finance & Acccounting
ISSN 19946-052X
2012, Vol. 4, No. 2

An E
Empiriccal Inveestigatiion of the
t Proffitabilitty Anom
maly
in the
t Indiian Sto
ock Marrket
S anjay Sehgaal,
Professor of
o Finance, Departmen
nt of Financial Studies,
Univerrsity of Delh
hi, India

Srivid
dya Subramaaniam(correesponding author),
a
Assistaant Professoor, Departm
ment of Econ
nomics,
SGTB Khalsa
K Colllege, Univerrsity of Delhi, India
E-mail: sriividyadse@
@gmail.com

Receiveed: Nov. 28, 2012 Accepted:

A D
December 10
0, 2012 Published:
P D
December 10,
1 2012
doi:10.55296/ajfa.v44i2.2777 URL: httpp://dx.doi.orrg/10.5296/aajfa.v4i2.27777

Abstract
This stuudy examinnes the profiitability anoomaly for th he Indian sttock markett using dataa for 493
compannies on the BSE from January 19996 to Deceember 2010 0. A negativve relation between
b
profitabbility and reeturns is em
mpirically cconfirmed which
w is in contrast too prior reseearch for
mature markets. Fuurther the ob bserved relaationship iss robust to choice
c of pro
rofitability measure.
m
The finndings can be explaineed by the ffact that more m profitab
ble firms teend to givee higher
dividennd payouts and
a are therrefore perceeived to be less risky by b investorss resulting in i lower
returns.. A positivee relationshiip between profitability y and payou uts and a neegative relaationship
betweenn payouts annd beta is obtained
o connfirming our argument.. The three ffactor Famaa French
model is able to explain reeturns on pprofitability y sorted portfolios whhich was not n fully
explained by CAPM. Thus the profitabillity anomaly y does not pose
p seriouss challenge to asset
pricing in the Indiaan context. Our findinggs have stro ong implicaations for accademicianss as well
as portffolio managgers. The sttudy contribbutes to equ uity markett anomaly lliterature esspecially
for emeerging markkets.
Keywords: Profitaability, Diviidend payouuts, Beta, CA
APM, Famaa French moodel
JEL codde: C22, C333, G12, G1
14, G15

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1. Introoduction
The liteerature on stock
s markeet anomaliees is extensiive and gro owing. Schw wert (2003)) defines
anomalies as emppirical results which aare inconsiistent with maintainedd theories of asset
pricing.. The CAPM M which posits
p a possitive and linear relation betweenn beta and security
returns was the acccepted paraadigm in thhe finance liiterature forr a long tim me. Howeveer in the
late 19770s, empiriical work appeared
a thhat exposed d the shortccoming of tthe CAPM. It was
observeed that that much of th he variationn in expecteed return is unrelated tto market beta b and
various company characterist
c tics could aaffect stock returns vizz. size, bookk to markett equity,
earninggs to price, past
p returnss, leverage aand momen ntum (Famaa & French,, 1992)1.It was w then
well esttablished thhat beta is inadequate
i tto explain returns
r and thus there is need to develop
multifacctor asset pricing modeels. Fama annd French (1993)
( deveeloped a thrree-factor model
m for
expecteed returns, which
w suggeests that exppected returrns on a porttfolio in exccess of the risk-free
r
rate aree explained by sensitiviity to markeet, size and d value factoors. The addditional risk
k factors
i.e. sizee and value are firm sppecific, yet tthey have proven
p to haave an imprressive explanatory
power in explainiing major anomalies of the CA APM for in nstance sizee, book to market,
earninggs to price, leverage.
Howeveer recent sttudies havee found thaat even the Fama and d French (11993) modeel is not
withoutt weaknessees. For instaance, the m
model fails to
t explain returns
r on pportfolios so
orted on
momenntum (Famaa & French,, 1996), acccruals (Sloaan, 1996), net n stock isssues (Loug ghran &
Ritter, 1995), (Ikeenberry, Laakonishiok & Vermaeelen, 1995))) and proffitability (F Fama &
French,, 2008). Fam ma and Freench (2008)) point out that
t the moodel fails too explain retturns on
portfoliios sorted onn accruals, momentum
m m and net sto
ock issues in
n all size grooups.
Asset ppricing anoomalies prim marily mom mentum, acccruals and d net stockk issues hav ve been
heavily researchedd for the dev veloped cappital marketts. It is the profitabilityy anomaly which
w is
comparratively lesss explored. Existing
E liteerature on profitability
p anomaly esstablishes a positive
relationnship betweeen profitabiility and retturns. Haug gen and Bak ker (1996) fifind more prrofitable
firms hhave greater expected returns. T They constru uct a modeel of expeccted returns which
includes various accounting,
a market annd past retu urn variablees and repoort that ev ven after
controllling for theese variablees more proofitable firm ms tend to have
h greateer expected returns.
They reelate profitaability of a firm to its growth potential and posit that ccurrently prrofitable
firms hhave greateer potential for futuree growth. This T indicates the proobability fo or faster
(slowerr)-than-averrage future growth in a stock’s earnings
e and
d dividendss. Cohen, Gompers
G
and Vuuolteenaho (2002)
( also
o find that m more profittable firms provide higgher averag ge stock
returns.. Fama and French (20 006) concluude that giv ven BM and d expected investmentt, higher
expecteed profitabillity impliess higher exppected returns. Fama and a Frenchh (2008) rep port that
the profitability annomaly exits only in tthe case off small stoccks. In thiis case they y find a
positivee relation between profitability annd returns and a presencce of signifi ficant hedgee returns
althouggh the hedgee portfolio returns
r are nnonexistentt in the casee of big stoccks, tiny sto
ocks and
market as a whole. Fitzpatriick and Oggden (2009)) find that the lowestt future retu urns are
associatted with thee lowest pro ofit quintilee and vice versa.
v Artmann, Finter and Kempf (2011)
1
Banzz (1981),Stattm
man(1980), Basu
B (1983), Bhandari (1988),
( De Bondt and Thaaler, (1985, 1987)
1 and
Jegadeessh and Titmann (1993).

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find avverage retuurns increasse as one moves fro

om low prrofitability portfolios to high
profitabbility portfoolios.
A possiible explanaation for th he positive rrelation obttained by thhe above stuudies could d be that
they vissualise proffits as the reeward for ggrowth and innovation, which expposes entrep preneurs
to greatter risk thuus resulting in higher rreturns. Thiis explanatiion is justiffied if we examine
e
profitabbility from the firm’s point
p of vieew. The firrm might haave borne hhigher operrating or
financiaal risk in managing
m its operations and profitss could be regarded
r as the reward d for risk
bearingg. Nevertheless the entire analysis of stock maarket anomaalies has to be carried out o from
the perspective off the investor who is in pursuit of o trading strategies w which can generate
g
positivee alphas. We thus purpo ort to explaain the existence of the profitabilityy anomaly from
f the
latter’s point of vieew as followws. If a firm
m is relatively more pro ofitable thenn investors perceive
p
it to be relatively less
l risky annd are hencce are willinng to acceptt low returnns. This would be a
counterr argument to t the existing explanattion to the profits
p ompensationn for bearing higher
as co
risks.
To eluccidate our point
p we hypothesise
h that risk (m
measured byb beta) annd share vaalues are
linked tto payouts in form off dividendss. Corporatee profits eaarned by firrms may be b either
retainedd and reinvvested by thhe firm or ppaid out to shareholders as divideends. Acco ording to
Amidu and Abor (2006), “prrofits have been regarrded as the primary inndicator of a firm’s
capacityy to pay divvidends”. Prruitt and Gittman (1991) show that current andd past year’s profits
are impportant in innfluencing dividends
d paayments. Yiadom
Y and Agyei(201 1) show sig gnificant
positivee associatioon between dividend ppolicy and profitability
p y. Aivazian,, Booth and d Cleary
(2003) find that for f emergin ng markets (including g India) higgh profits ttend to meean high
dividennd paymentss. Given thaat higher prrofitable firm ms pay high her dividennds we next explore
the inflluence of corporate
c diividend pollicies on stock prices. The bird iin the hand d theory
(Gordonn, 1963) arrgues that investors
i prrefer a dividend today y to a highlly uncertain n capital
gain froom future innvestments tomorrow.
t H
Hence investors value high payout ut firms morre highly.
Shefrin and Statmaan (1984) develop
d a b ehavioural theory in which
w they sshow that investors
want diividends beecause of self control and due to o choices made
m underr uncertainty y. Their
theory ssuggests thaat some invvestors wouuld be willin ng to pay a premium fo for dividendds due to
self conntrol reasonns or wish to avoid reggret. Investo ors finance consumptioon out of diividends
and do not want too dip into caapital. Also there is em mpirical eviddence to suppport the signalling
functionn of divideends. Sincee managerss have morre informattion about the health h of the
companny, dividendd increases signal a heealthy grow wing firm. An
A increase in dividend d payout
may bee interpretedd as the firm
m having g ood future profitability y and thereefore its shaare news
will reaact positiveely. Asqiuthh and Mulllins (1983) find that the t initiatioon of divid dend has
significcant positivee impact on
n the firm’s stock pricee. The posittive relationn between dividend
d
policy aand stock prrices was allso shown bby John and d Williams (1985). Connsequently if a more
profitabble firm payys a higherr dividend, investors would
w buy that stock and drive its i price
high.
Dividennd payouts not only enhance
e firmm values owing
o to theeir informaation conten nt but if
investorrs perceive high dividend payingg companiess as less rissky it will aalso result in
i lower

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cost of equity/requuired return

ns. This willl positively
y impact firm
m values ass one can see
s from
the valuuation equattion

V (1)

where X is the exxpected stream of dividdends/cash flows to in

nfinity, k is the cost off equity/
a V is thee equity vallue.
requiredd returns off investors and
That innvestors perrceive high h dividend paying com mpanies as less risky is reconfirrmed by
evidencce in the literature on n relationshhip betweeen dividend d paymentss and mark ket beta.
Severall studies havve explored d the relatioonship of divvidends payyouts with m market betaa. Logue
and Meerville (19772) documeented that investors are a assured of the flow ow of return ns from
dividennd payouts than the flow w of returnss obtained from
f higherr stock pricees. This lead
ds to the
inverse relationshipp between payouts
p andd beta. Beavver, Kettler and Scholees (1970) asssert that
ceteris paribus firmms with low wer payout ratios are more risky. This is beecause payo out ratio
shows tthe managem ment’s percception of uuncertainty with
w respectt to firm’s eearnings. Brreen and
Lernen (1973) andd Gu and Kim K (2002) purport an n inverse relationship bbetween systematic
risk andd high dividdend payou ut. This wouuld mean th hat higher dividend
d paaying firms are less
risky annd hence invvestors dem mand a loweer premium.. Thus we have h a countter argumen nt which
states thhat high proofitable firm
ms pay highher dividen nds which arre viewed aas less risky y by the
investorrs and hence they are willing
w to acccept lower returns.
This paaper has been motivaated by thee following g research gaps. Firsttly a study y of the
profitabbility anomaaly in the Indian
I stockk market th
hus far has not
n been coonducted. Secondly
S
the anom maly for the mature markets
m has bbeen analyssed from thee point of vi
view of the firm
f and
not thee investor. To fill thiss void in tthe literature this pap per examinees the proffitability
anomalyy in the Indian stock market, invvestigates th he reasons for its exisstence and explores
e
possiblee explanatioons. We speecifically exxamine the following
f prropositions
 Whhat is the rellationship between
b firm
m profitabiliity and stock returns?
 Do more profiitable firms pay higher dividends?
 Cann profitabiliity anomaly y be explainned by CAPM based market factorr and therefo
fore does
the sloppe of the maarket factor bear a relattion with div
vidend payo
outs?
 Cann the Famaa French multi
m factor model exp
plain returnss that are ppossibly miissed by
CAPM??
 Aree there any links betweeen Fama Frrench size and
a value faactors and fiirm payoutss?
The objjectives of the
t study aree
1. Is tthe profitabiility anomally in returnss empiricallly validated
d in Indian ccontext?
2. Does the rellationship between
b pprofitability and returrns reflect firm or investor
perspecctive?

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3. Cann the profiitability ano

omaly be ccaptured by
y standard asset pricinng models such as
CAPM and Fama French?
F
4. Do the risk facctors bear a fundamentaal relation with
w corporaate payouts??
The papper is organnised as folllows. Sectiion 2 descriibes the datta and theirr sources. Section 3
explains the methoodology folllowed. Secction 4 givees the empirical resultts. The lastt section
contains summary,, policy imp plications annd concluding remarks.
2. Dataa
The sam mple used consists of 493 compaanies that form f part of
o BSE-5000 equity ind dex. The
study uses month ende closing adjusted shhare prices (adjusted
( fo
or capitalisaation such as bonus,
rights aand stock spplits) from Jan 1996 tto Dec 201 10 (180 mo onthly obserrvations). BSE-500
B
index reepresents nearly 93% of the totall market cap pitalization on BSE, acccounts for 95% of
trading activity, annd covers alll 20 major iindustries of the economy. Hence the sample is fairly
represenntative of market
m perfformance. TThe Bombaay Stock Exchange (B BSE) -200 index is
used ass the markett proxy. It isi a broad bbased valuee weighted index whichh is constru ucted on
the linees of S&P5500 (USA). The montth end sharre price serries have b een converrted into
percentage return series
s for fu
urther estimaation.
Market capitalisatiion is used as
a the size pproxy. It is calculated
c as
a the naturaal log of price times
shares ooutstandingg. Price to book
b (inverrse of BE/MME) is used d as the val
alue proxy. Price to
book vaalue per shaare represennts the securrity price ov
ver a company’s bookk value. We use two
alternattive measures for profits viz returnn on equityy and return on assets. RReturn on equity
e is
calculatted as the income
i avaailable to coommon stocckholders forf the mosst recent fisscal year
dividedd by the averrage commo on equity. R
Return on asssets is calculated as neet income sccaled by
averagee total assetss.
Data onn share pricces, market index all ccompany ch haracteristiccs has beenn obtained from
f the
Thomsoonone databbase of Thomson Reuteers. The implicit yieldss on 91-dayy treasury biills have
been ussed as risk-ffree proxy as
a is the staandard practtice in finan
nce literaturre. The dataa for this
has been obtained from the RB BI monthly handbook of o statistics.
We usee the firm’s dividend paayout ratio tto representt the dividend decisionn. Dividendss payout
ratio is calculated as equity dividend
d thaat is paid to
o equity shaare owners as a percenntage of
total proofit after taxx. Data on this
t has beenn obtained from
f CMIE E-Prowess.
3. Meth
hodology
3.1 Testt the relatioon between profitability
p y and return
ns
We form m single sorrted portfollios based oon each meaasure of profitability. Inn Decemberr of year
t-1, the securities are
a ranked on the basiis of the profitability definition
d un
under considderation.
The rannked securitties are then n classifiedd into five portfolios
p P1
P to P5 andnd equally-w
weighted
monthlyy excess retturns are estimated for these portffolios for the next 12 m months (t). P1
P is the
portfoliio consistingg of 20% of companiees with loweest attributee while P5 cconsists of top
t 20%
compannies with hiighest attribbute under cconsideratio on. P1 and P5 are refeferred henceeforth as

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corner pportfolios inn the study. The portfollios are re-b

balanced at the end of D
December of o year t.
We deffine a year asa calendar year from JJanuary to December.
D Sample
S secuurities are sorted
s in
Decembber of eachh year beg ginning in December 1995 and d portfolio formation process
repeatedd till we reaach Decemb ber 2009.
In the fi
first step of our
o method dology we obbserve the unadjusted
u mean
m excesss returns accross the
portfoliios created, and ascertaain the relatiionship betw
ween profitaability and rreturns.
3.2 Relaationship beetween proffitability andd payouts
To estim mate relatioonship betw
ween divideend payoutts and profifitability wee run a pannel OLS
regressiion where the
t dividend d payout is the depend
dent variablee and the exxplanatory variable
is profitts. We estim
mate the folllowing equaation
Payoutt i,t = λ0 + λ1 profits i,t +ε t (2)
where λ0 is a constant. A significant
s positive vaalue of λ1 would inndicate thatt more
profitabble firms pay
p higher dividends and vice versa.v To confirm
c theese results we also
constructed profitaability sorteed portfolioos and calcculated the average paayout ratios of the
corner pportfolios.
3.3 Asseet pricing teest - CAPM
M
CAPM regressionss are run on n each of thhe five porttfolios usin
ng the familliar “excesss return”
version of the markket model equation.
e
Rpt – Rft = a + b (Rmt – Rftt) + et (3)
where Rpt – Rft is the monthly
y excess retturn on the portfolio i.e. return onn portfolio P minus
risk freee return (Rft),
ft

Rmt – Rft is the exccess market return i.e reeturn on maarket factor minus
m risk ffree return,
et is the error term,
a (interccept) is a measure
m of ab
bnormal proofits and
b is the sensitivity coefficient of market ffactor.
The CA APM impliees that exceess returns on a portfo olio should be fully exxplained by y excess
market returns. Hence,
H the expected value of a (the interrcept term)) should be b 0. A
significcantly positiive (negativ
ve) value off ‘a’ (interceept) impliess extra-norm
mal profits (losses).
If theree is a signiificant positive or neggative intercept in thee CAPM sppecification, then a
CAPM anomaly exxists.
3.4 Relaation betweeen beta and
d payouts
The purrpose of esttimating thee relation beetween betaa and payouts is to evalluate if high
h payout
firms aare perceiveed to be leess risky byy investors. We first estimate sttock beta for f each
individuual firm by regressing a firm’s exxcess month hly stock return againstt the excesss market
return uusing rollinng three yeear regressioons over thhe entire tim
me period. The variab ble beta

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measurees the co movement of securityy return wiith the market returnn and is caalled the
systemaatic risk of the
t equity security
s of ffirm i. The value
v of βi is obtained from the fo
ollowing
time serries regressiion for each
h firm in thee sample as follows
Yi = α +βi X (4)
where Yi is the exccess monthly return of a firm i ,
X is thee excess maarket return,
α the inntercept andd βi (beta) is the stock bbeta for firm
m i.
Once thhe value of beta is avaailable for eeach firm ov
ver the entire sample pperiod, we estimate
the relaation betweeen beta and payouts usiing panel OLS in the fo
ollowing eqquation
beta i,t = γ0 + γ1 payoutts i,t +ε t (5)
where bbeta is the estimated
e yearly beta ffrom equation 4 and γ0 is the inteercept. The value of
γ1 in thiis equation shows
s the relationship between beeta and payo
outs. To connfirm our reesults on
relationnship between beta and d payouts, w we construccted porttfolios on thhe basis of payouts
and calcculated the average bettas of the coorner portfo
olios.
3.5 Asseet pricing teest-Fama French
F (FF) model
If a CA
APM anomaaly exists th hen we atteempt to evaluate if the excess retuurns of the stylized
portfoliios that are missed by CAPM cann be explainned using th he three facctor model of
o Fama
and Freench (1993) specified as
a follows. .
The FF Model is given by:
Rpt – Rft = a + b (Rmt - Rft) + s(SMBt )+ h(LMHt )+
) et (6)
Where SMBt is thee monthly reeturn on thee size mimiccking portfo
olio,
LMHt is the monthhly return on
n the price-tto-book mim
micking porrtfolio,
s and h are the senssitivity coeffficients of SMBt and LMH
L t

The othher two term

ms are same as defined in equation
n (3).
We estiimate the SM MB and LM MH as follow ws. In each year of the sample perriod t, the stocks are
split intto two grouups- big (B)) and small (S) - based d on whetheer their mark rket capitalization at
the end of Decembber of every y year in thee sample peeriod is abovve or beloww the median n for the
stocks oof the comppanies inclu uded. The pprice to boo ok equity raatio is calcuulated in thiis month
for all tthe companiies. The stoocks are noww split into two equal P/B
P groups.. Then we construct
c
four poortfolios vizz. S/L, S/H,, B/L, B/H.. from the intersection
i n of the twoo size and two t P/B
groups. Monthly equally
e weig ghted returnn series aree calculated for all porrtfolios from
m Jan of
year t too Decemberr of year t.

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The Fam ma and Frennch model uses

u three eexplanatory variables forf explaininng the crosss section
2
of stockk returns . The
T first facctor is the exxcess market return whhich is the m
market indeex return
minus tthe risk-freee return. Thhe second iis the risk factor in reeturns relatiing to size – small
minus bbig (SMB). To calculatte the montthly return of o the SMB B factor we subtract thee simple
averagee of the monnthly returnns of the tw
wo big size portfolios
p (BB/L, B/H) ffrom the average of
the twoo small sizee portfolios (S/L, S/H) as this facttor has about the samee weighted--average
price too book it is free
f from vaalue effects..
SMB=(S/L
L+S/H)/2-(B
B/L+B/H)/2
2 (7)
The thirrd factor is LMHt whicch is relatedd to value. It is constru
ucted as folllows such that
t it is
indepenndent of sizee factor.
LMH=(S//L+B/L)/2-((S/H+B/H)//2 (8)
If the inntercepts froom the FF regressions
r are insigniificant and the
t interceppts from thee CAPM
regressiions are siggnificant, then this impplies that thee FF specifiication is abble to captu
ure cross
sectionaal patterns in average stock returnns that are missed by CAPM. Grreater sensitivity of
sample portfolio reeturns to the size and vvalue risk factors
f is shown by higgher factor loadings
l
i.e s andd h for thesee factors. We
W further vverify if the corner portfolios (P1 aand P5) com mprise of
stocks with particcular attribu utes i.e. smmall (big) size, low (high) P/B ratio. Succh stock
characteeristic patteerns in the sample
s porttfolios shall support thee strong perrformance if
i any of
the FF m model.
3.6 Relaationship beetween divid
dend payouut, size and value
v factorrs
We nexxt evaluate if FF size and
a value ffactors havee their trackks in firm ppayout ratios i.e. do
small annd low P/B firms tend to pay low wer dividendds and hencee are perceiived by inveestors to
be more risky vis--a-vis big and
a high P//B firms. To estimate the relatiionship of size s and
value faactors with dividend paayouts respeectively we estimate the two panell OLS as follows
Size i,t = γ0 + γ1 payou
uts i,t +ε t (9)
P/B i,t = γ3 + γ4 payou
uts i,t +ε t (10)
where γ0 and γ3 aree intercepts and γ1 annd γ4 would indicate thee relationshiip of size annd value
factors with divideends if any. To confirm
m these resullts we also construct
c poortfolios bassed on
size, P/B
B and comppute the aveerage valuess of dividen
nd payouts for
f corner poortfolios.
4. Emp
pirical Resu
ults
We beggin the em mpirical resu
ults by esttimating thee relationsh
hip between
en profitability and
unadjussted returns.
Table 1. Unadjusteed average monthly
m exccess returnss on profitab
bility sortedd portfolios
Panel A
A. ROE sortted portfolio
os

2
Constrruction methoodology for size
s and valuue factors hass been adopteed from Sehggal, Subramaniam and
Morandiiere(2012).

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P1 P2 P3 P4 P5
Mean t- Mean t--stat Meean t-statt Mean t-stat Mean t-
stat stat
0.023 2.461 0.017 2.205 0.0 14 1.927
7 0.017 2.459 0.015 2.197
Panel B
B. ROA sorrted portfolioos
P1 P2 P3 P4 P5
Mean t- Mean t--stat Meean t-statt Mean t-stat Mean t-
stat stat
0.026 2.789 0.032 3.141 0.0 21 2.554
4 0.019 2.648 0.015 2.215

Table 1 1, Panel A shows

s that the unadjussted returnss on ROE sorted
s portffolios are laarger for
less proofitable stoccks as comp pared to moore profitable stocks. The
T return ddifferential between
b
less proofitable andd more profiitable stockks is 1% perr month (t-sstat=2.01) w
which is abo out 12%
p.a. andd hence is robust.
r Panel B showss that sortinng on ROA the averagge returns are again
significcantly higheer for low profitabilityty stocks ass compared d to that off high proffitability
stocks. The lowestt profitabiliity portfolioo produces an abnorm mal return o f 2.6 % per month
whereass the highesst profitabillity portfoliio produces an abnormmal return off 1.5 % perr month.
Thus wwe find a neggative relation betweenn profitability and retu urns which iis in contraast to the
results oobtained forr mature maarkets.
Is it posssible that thhe Indian in
nvestor findds high proffitable stock
ks to be lesss risky due to
t which
he is w willing to accept
a loweer returns? To answer this quesstion we w want to explore the
informaation contaiined in proffits which ccould contrribute to thee risk argum ment. We visualise
v
one riskk factor whhich could be b linked too dividend payouts.
p Heence we calcculated the relation
betweenn profitabiliity and payo outs.
Table 22. Empiricall results of the
t panel OL
LS regressio
on of payou
uts on profittability.
Payout i,t = β0 + β1 profitability
y i,t + ε t

ROE ROA
β0 t(β0) β1 t(β1) β0 t(β0) β1 t(β1)
0.255* 38.475 0.032*
* 3.2222 0.24
44* 18.16 0.2231* 2..074

*Denotes significaance at the 5%

5 level usiing a two taailed t-test
Results of panel OLS
O regresssion3 (tablee 2)show that firm with h larger proofits(both ROE
R and
ROA) aare more liikely to paay higher ddividends while
w compaanies that hhave compaaratively
lower pprofits wouldd adopt low
wer payouts.. The resultss appear to be consistennt with the findings
of otherr empirical studies (BBaker, Farreelly & Edellman RB, 1985, Pruittt & Gitman n, 1991).
The aveerage valuees of payou uts calculateed for corneer portfolios sorted onn profitabiliity (both
ROE annd ROA) strengthen
s our
o results. We find th hat averagee payout forr low ROE E (ROA)
sorted portfolio is
i 20.12 %( % 18.01% %) and for high ROE E (ROA) ssorted porttfolio is

3
The eqquation has been estimated
d using fixedd effects paneel OLS metho
od, which hass been chosen
n over the
random eeffects methood based on Wu-Hausman
W statistic.

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29.67 %%( 31.14% %). Corporaate dividendd policy ten nds to varyy directly w
with currentt profits.
Currentt profits maay contain informationn about futu ure profits and hence large payouts may
send a ppositive signnal leading to stock priice appreciaation.
Table 3. Empiricall results based on one ffactor CAPM
M
Panel a. ROE sorteed portfolioss

Portfolioo A B t(a) t(b) Adj. R2

P1 0.0012 1.166 2.0778 17.810 0.638
P2 0.0007 1.086 1.817 23.961 0.762
P3 0.0004 1.026 1.2440 23.269 0.751
P4 0.0007 0.961 2.3774 24.803 0.774
P5 0.0006 0.988 2.0008 30.003 0.833
Panel B
B. ROA sorteed portfolioss
Portfolioo A B t(a) t(b) Adj. R2
P1 0.0014 1.177 2.485 18.223 0.664
P2 0.0020 1.124 2.810 13.681 0.527
P3 0.0009 1.125 2.3000 23.582 0.768
P4 0.0009 0.994 2.635 26.171 0.803
P5 0.0004 0.930 1.699 27.33 0.816

CAPM results (Taable 3) show w that the eextra normaal returns (aafter adjustinng for mark ket risk)
on ROE E sorted porrtfolios is 1..2% per moonth for less profitable stocks
s and 00.6% per month
m for
more prrofitable stoocks. The siignificant inntercepts off corner porttfolios conffirm the presence of
a profittability anom maly within n the CAPM M frameworrk. We how wever find thhat the marrket beta
for lesss profitable stocks(P1) is higher aas compared d to more profitable
p sttocks(P5), showing
s
that lesss profitable firms aree more riskky. The beeta coefficieent of bothh portfolioss is also
statisticcally significant which means thatt the market return factor is imporrtant in cap pturing a
large am mount of vaariation in co ommon stocck returns. WeW find thaat the alphass of P1 and P5 have
soberedd down duee to the con ntribution off beta. Resu ults on ROA A sorted poortfolios aree in line
with thaat obtained for ROE. The T extra noormal return n (after adjuusting for m
market risk) is 1.4%
per month for less profitablee stocks andd 0.4% perr month forr more proofitable stoccks. The
interceppt of the loower profitaability portffolio (P1) is i statisticaally significcant confirm
ming the
presencce of a profi fitability ano
omaly withiin the CAP PM framewo ork. We recconfirm thatt market
factor iss able to exxplain part of
o the profit ability anom
maly. Thesee results aree in line with Louge
and Meerville (1972) who find d negative rrelation bettween profitability andd beta. They y reason
that invvestors perceive profiitability as an “inversse surrogatee” of businness risk. Previous P
findingss of Scherrrer and Maathison (19996), Gu and d Kim (200 02) and Leee and Jang g (2006)
indicateed a negativve relationsh hip betweenn profitabiliity and systematic risk.. From an in nvestors
perspecctive who iss developin ng a tradingg strategy a highly pro ofitable firm
m is less riisky and
hence should proviide less retu urns.

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Table 44. Empiricall results of the

t panel OL
LS regressio
on of beta on
o dividend payouts
beta i,t = γ0 + γ1 payyouts i,t +ε t

γ0 t(γ0) γ1 t(γ1) Adj.R2

A

0.967* 20.949
9 --0.074* -3.235 0 .002

*Denotes significaance at the 5%

5 level usiing a two taailed t-test
The ressults of paanel OLS4 show that market beeta is significantly neg egatively reelated to
dividennd payouts (table
( 4). Firms
F with hhigh payou uts (profitabbility) are pperceived too be less
risky innvestments while
w firms with persisstently low payouts (prrofitability) are perceiv ved to be
more riisky. This is expected d as firms which are less profittable and hhence do not n have
adequatte funds ressulting in lo
ow/no dividdends are typ pically morre risky (higgher beta). We find
that sincce beta show
ws a negativve link withh payouts, itt absorbs a portion
p of rreturns in CAAPM.
Table 55. Empiricall Results for the three factor Famaa French Model
M based on Market, Size &
Value ffactors.
Panel a.ROE sortedd portfolioss

Portfolioo A B S H t(a) t(b) t(s) t(h) Addj.R2

P1 -0.00053 1.066 6 0.686 00.522 -0.120 20.983
3 7.794 5.759 0.791
P2 0 1.024
4 0.415 00.322 -0.108 26.944
4 6.302 4.742 0.839
P3 -0.0002 0.969 9 0.420 00.284 -0.8
801 26.057
7 6.530 4.277 0.830
P4 0.0002 0.927
7 0.324 00.137 0.8778 25.952
2 5.248 2.159 0.816
P5 0.0001 0.997
7 0.420 - 0.269 0.6009 35.901
1 8.748 -5.433 0.886
Panel b.. ROA sorted portfolios
Portfolioo A B S H t(a) t(b) t(s) tt(h) Addj.R2
P1 0.0002 1.084 0.523 0. 554 0.3677 20.776 5.821 5.931 0.7
789
P2 -0.0003 0.965 1.090 0. 827 -0.7880 23.239 15.234 11.108 0.8
884
P3 0 1.070 0.502 0. 210 0.0855 26.922 7.333 22.950 0.8
845
P4 0.0002 0.961 0.371 0. 082 0.8099 28.403 6.370 1.350 0.8
850
P5 0 0.927 0.429 -00.224 0.1200 32.142 8.626 -4.341 0.8
873

The FF results (Taable 5) show w insignificcant interceppts for loweest profitabiility portfollios(both
ROE annd ROA) owingo to contribution oof both sizee and valuee factors. FFF regression ns show
that botth SMB andd LMH coeffficients aree higher forr P1 as comp pared to P55 confirming g role of
size annd value factors
f in explaining profitabilitty based returns.
r Thhe alpha of P1 is
predomminantly capptured by vaalue factor aand marginaally by sizee factor. Hennce the threee factor
model aabsorbs thee profitabilitty sorted reeturns that are
a missed by CAPM.. Further FF F results
are robuust to choice of profitab
bility proxyy i.e. ROE and
a ROA.
4
The eequation has been estimateed using randdom effects panel
p OLS meethod, whichh has been cho
osen over
the fixedd effects methhod based on Wu-Hausmann statistic.

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When w we investiggate the aveerage size aand P/B5 foor the profittability sortted portfolio
os (both
ROE annd ROA) we w find thaat P1 is acttually smalll size and low l P/B viis-a-vis P5 i.e. less
profitabble firms arre relatively
y distressed and smalleer in size (ffor use of PP/B as a measure of
relativee distress see
s Chan and a Chen( 1991)). Sinnce less prrofitable fiirms are reelatively
distresssed and smaall in size, it
i is found that small sized comp panies and llow P/B companies
give lowwer dividennd payouts and
a hence arre perceived d to be more risky by innvestors.
Next wee try to devvelop a risk story
s for sizze and valuee factors.
Table 66. Empiricall results of panel
p OLS regression of size on dividend
d paayouts and value
v on
dividennd payouts
Size i,t = γ0 + γ1 payyouts i,t +ε t
P/B i,t = γ3 + γ4 payyouts i,t +ε t

γ0 t(γ0) γ1 t(γ1) A
Adj γ3 t(γ3) γ4 t(γ4) Adj.R2
R2
22.817 609.45 0.125 1.96 0 .001 3.13 3.904 0.989 0.782 0

Our paanel OLS reesults (table 6) show weak posiitive relatio onship betw ween firm sizes and
payoutss and a weaak positive relationshiip between P/B and payouts. Exaamining thee corner
portfoliios formed ono the basiss of size andd P/B it is observed
o th
hat small and nd low P/B firms
f do
exhibit lower payoouts vis-a-v vis big and high P/B firmsf (averaage payoutss for small firms is
19.17 %%and for big firms is 30.15%.
3 Avverage payo outs for low
w P/B firms is 20.26 % and for
high P/B B firms is 30.64%).
3 Hoowever in thhe absence of o any statisstically signnificant relaationship
one migght infer thaat there cou
uld be other reasons forr the risk sto ory leading to these facctors for
instancee small firmms are expoosed to highh operation nal, financiaal risks owin ing to the nature
n of
their buusiness and more liquiddity risk owwing to investor neglectt. Low P/B stocks on the t other
hand reepresent relaatively distrressed firmss as show byb weaker track
t recordd of their paast sales
and earnnings growtth rates (seee Fama and French (19 995)).
5. Summary and Conclusion
C ns
Prior reesearch has confirmed a positive rrelation bettween profittability andd returns forr mature
marketss (see Famaa and French h (2008)). TThese resultts can be ex
xplained if w we look at the
t issue
from enntrepreneur’’s perspectiv
ve thus treaating profits as a reward
d for risk beearing.
Our ressults howevver confirm a negativee relation beetween profitability annd returns whichw is
robust tto choice off profitability measure.. This could d possibly be
b explainedd by examining the
problemm from inveestor’s persp pective. Moore profitable firms tennd to pay hiigher divideends and
thereforre are perceeived to be less risky by investorrs. Thus a negative
n rellation is po
ostulated
betweenn dividend payouts
p and d firm betass. In other words
w more profitable ((and higher payout)
firms shhould provvide lower returns.
r It is equally important to t know w whether proffitability
based aanomalous pattern
p in reeturns couldd be explain dard asset ppricing models. One
ned by stand
5
For ROOE (ROA) soorted portfolio
os the averagge values of market
m cap (siize) for P1 iss 22.42 (22.53
3) and for
P5 is 22.53(23.92).Foor ROE (ROA A) sorted porrtfolios the av
verage values of P/B for PP1 is -0.87(-0.88) and
for P5 is 8.09(8.81).

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factor C
CAPM is partially able to expplain the allphas on profitability
p y sorted po ortfolios.
Dividennd payouts confirm thee risk argum ment for thee market factor as a neegative relaationship
betweenn payout annd beta is em
mpirically coonfirmed.
It is fuurther foundd that the FF
F size andd value based factors absorb the profitabilitty based
returns that are misssed by CAPM. Hencee the profitab bility anommaly does noot pose an em
mpirical
challengge to multtifactor assset pricing framework k in Indian n context. These risk k factors
howeveer do not bear signifficant relattionship wiith payout ratios, thuus suggestiing that
alternattive explanaations mightt be neededd to justify th
heir risk preemiums.
The stuudy has stroong implicaations for aacademician ns who are searching ffor a ration nal asset
pricing theory that can explain n prominentt equity maarket anomalies and hass a universaal appeal.
There aare also im mplications for investm ment managgers who are
a continuoously in pu ursuit of
profitabble style bassed trading strategies.
The preesent researrch contribu
utes to asseet pricing an
nomaly literrature especcially for em
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