Dissecting the effectiveness of firm financial strength in predicting Chinese stock market

•Firm financial strength proxied by F-score has the power to predict Chinese stock returns.•Behavioral mispricing can partially explain the predicting power.•Investment-based q-theory also helps to explain for the predicting power. This paper studies whether the financial strength measure, F-score, can predict returns in the Chinese stock market and its economic explanations. The results suggest that high F-score firms can generate high expected stock returns. Additionally, the predictability of F-score is robust after controlling for common factors in Fama–French models, and other firm characteristics and risks. We find that the premium generated by F-score in Chinese stock market is stronger following higher level of investor sentiment and for firms with higher limits to arbitrage and lower investment frictions, consistent with both the behavioral mispricing and the investment-q asset pricing theories.