Dissecting The Gross Profitability Anomaly

Novy-Marx (2013) documents that there is a positive relation between firms’ gross profitability (GP) and average stock returns. This finding contradicts prior literature that finds a weak relation between profitability and stock returns, when other measures of profitability are adopted. He contends that a positive relation between expected profitability and average stock returns is consistent with valuation theory. As such, GP is potentially a superior proxy of expected profitability, whereby firms with high current GP are expected to have high profitability in the future. This thesis further examines the drivers that cause a positive relation between GP and stock returns.