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Q-Theory, Mispricing, and Profitability Premium: Evidence from China

Using various empirical measures, we find that, in China, firms with high profitability generate substantially higher future stock returns than those with low profitability. This positive effect of profitability on expected returns is robust to controlling for other firm characteristics and risks. We show that the profitability premium is stronger among firms with low investment friction, which is consistent with the implications of investment-based q-theory asset pricing models. However, the premium is not stronger among firms with high limits to arbitrage, contradicting behavioral mispricing explanations.