The profitability effect: An evaluation of alternative explanations

Many recent studies have confirmed that firms with higher profit would generate higher future returns, so-called the profitability effect. Based on the legal and economic transformation of the Taiwanese market over the past two decades, this study examines the efficacy of the profitability effect proxied by return on equity (ROE) across multiple time periods and explores the rationale of this effect through its performance over time. The results suggest that the possible rationale of the profitability effect comes from risk compensation rather than behavioral bias. The performance of the profitability effect culminates during market declines and when market volatility is high and coincides with favorable economic conditions. However, the performance of the profitability effect is unrelated to investor sentiment.