DO PROFITABLE FIRMS EARN HIGHER STOCK RETURNS IN FRONTIER MARKETS? EVIDENCE FROM THE COLOMBO STOCK EXCHANGE

Abstract

This study investigates the validity of the profitability anomaly in the Colombo Stock Exchange (CSE) by examining whether firms with higher profitability earn higher expected returns. Using monthly data for all listed non-financial firms from April 2010 to December 2023, two profitability measures, operating profitability and cash profitability, are analyzed through portfolio sorts and monthly cross-sectional regressions controlling for standard risk factors, including Beta, Size, Value, Investment, and Momentum. Portfolios are formed based on quintiles of operating profitability and quartiles of cash profitability, rebalanced monthly to reflect changing firm characteristics. The results reveal that neither operating nor cash profitability consistently predicts stock returns once these factors are considered. Although high-profitability firms tend to show slightly positive coefficients, these effects are economically small and statistically insignificant, indicating only a weak and tentative profitability premium. The findings demonstrate that profitability has limited incremental predictive power in the CSE and that its effect is conditional and context-dependent. Profitability should therefore be viewed as a complementary rather than a standalone determinant of stock returns. This study contributes to asset pricing literature by extending the examination of the profitability anomaly to a frontier market context, offering insights for both researchers and practitioners into the role of firm characteristics in explaining expected returns.