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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.

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.