Big is brilliant: Understanding the Chinese size effect through profitability shocks

Taking a dynamic view, this paper assesses the extent to which profitability shocks affect the size premium in the Chinese market. In the short run, there is a significant U-shaped relationship between size and profitability shocks; i.e., both small and large firms experience large and (in most cases) positive profitability shocks, while firms with medium market capitalizations display small profitability shocks. In the long run, profitability shocks in large firms remain large and stable, while profitability shocks in small firms decrease sharply. Adjusting for profitability shocks increases the returns of small firms but decreases the returns of large firms, indicating that large and positive profitability shocks in small firms cannot bring investors sizable returns even though the correlation between profitability shocks and returns is positive. Mismatches between profitability shocks and the per-unit return impact of such shocks (e.g., when firms experience positive shocks but the market reacts to these shocks irrationally) can help explain this phenomenon. Our work reveals that in terms of fundamentals, large firms are very worthy of investment owing to their superb fundamental performance, i.e., large and persistent profitability shocks.