Firm’s quality increases and the cross-section of stock returns: Evidence from China

Abstract

Using a quality increase factor from a dynamic perspective to capture the changes in the quality of firms over a period of time, we explore the impact of firm’s quality increases on the cross-section of stock returns. The empirical results show that there is a significant positive quality increase premium in Chinese stock market; i.e. the firms with high quality increases generate higher returns than those with low quality increases. Quality increases have both short-term and long-term predictability on stock future returns. Moreover, the predictive information contained in the quality increases is not subsumed by the quality level, or other well-known firm characteristics and risks. We further show that underreaction caused by the positive feedback trading and investor’s negligence contributes substantially to this premium, which is consistent with the implications of irrational mispricing rather than rational pricing based on risk compensation.