Sticky Expectations and the Profitability Anomaly

We propose a theory of the profitability anomaly. In our model, investors forecast future profits using a signal and sticky belief dynamics. In this model, past profits forecast future returns (the profitability anomaly). Using analyst forecast data, we measure expectation stickiness at the firm level and find strong support for three additional model predictions: (1) analysts are on average too pessimistic regarding the future profits of high-profit firms, (2) the profitability anomaly is stronger for stocks that are followed by stickier analysts, and (3) the profitability anomaly is stronger for stocks with more persistent profits.