Excess returns on idiosyncratic profitability: Evidence from a hedge portfolio strategy

This study investigates the influence of firm-idiosyncratic profitability on stock pricing decisions and whether a trading strategy based on idiosyncratic profitability can generate significant hedge portfolio abnormal returns. We disaggregate a firm’s profitability into three components—a market component, an industry component, and a firm-specific component, which we label as idiosyncratic profitability. We document that a trading strategy based on idiosyncratic profitability generates significant hedge portfolio returns. Our results are robust in that our hedge portfolio returns still exist after controlling for known risk factors and previously documented anomalies.