Investor sophistication, investor sentiment, and cash-based operating profitability

Abstract

We examine the return dynamics of cash-based operating profitability (CBOP)–sorted portfolios and evaluate whether the associated abnormal returns are sensitive to investor sophistication and investor sentiment. We show that the interaction between CBOP and firm size provides incremental information about expected stock returns as portfolios with small size and high CBOP earn higher abnormal returns than portfolios based on size or CBOP alone. The CBOP-size-sorted portfolio corresponding to high investor sophistication generates statistically significant abnormal returns, but the presence of investor sophistication do not weaken the net effect of CBOP. We find that while investor sophistication does not provide a potential explanation for the size-and-CBOP-interaction effect, investor sentiment captures mispricing attributed to firm size and CBOP. The CBOP mispricing for small (large) stocks is positively (negatively) related to investor sentiment. The finding that investors misinterpret the financial accounting information related to CBOP lends support for the limited-attention effect.