Abstract

Prior research shows that a measure of Q-Score, capturing the joint effect of conservative accounting and investment growth, significantly predicts future stock returns. Yet, whether the documented returns reflect compensation for risk or mispricing remains an open question. Under mispricing explanations, investors do not anticipate the reversals of temporary investment growth. In this paper, I show that (i) the predictable stock returns associated with the Q-Score are concentrated among firms with the largest future investment reversals (ii) a parsimonious model that is independent of stock prices can identify future investment reversals ex-ante with reasonable power, (iii) the returns to the Q-Score strategy conditional on ex-ante identifiable future investment reversals are significantly larger than the returns to the unconditional Q-Score strategy, and (iv) analysts’ earnings expectations do not anticipate the predictable investment reversals and are systematically biased. Overall, the results suggest that investors and financial analysts do not anticipate the temporary nature of investment growth under conservative accounting.