Does expected idiosyncratic skewness of firms' profit predict the cross-section of stock returns? Evidence from China

Motivated by existing evidence of a preference among investors for assets with lottery-like payoffs and for portfolios that are under-diversified, this study investigates the relation between expected idiosyncratic skewness of firms' profit (EISP) and cross-sectional stock returns, using samples from the Chinese A-share market. Portfolio-level analyses and firm-level cross-sectional regressions suggest that firms with higher EISP have lower expected returns than those with lower EISP. A long-short value-weighted portfolio can earn an annualized risk-adjusted excess return (i.e., Fama-French five-factor alpha) of 11.3% when sorting by the EISP. The negative effect of EISP on the cross-sectional stock returns is robust to controlling for well-documented firm characteristics and risk factors, rather than being subsumed by firms' profit instability or accounting-based downside risk. Of particular interest, the effect is more pronounced among stocks with more lottery-like characteristics, indicating that the immaturity of investors is an underlying driver of the mispricing in the effect. [Display omitted] •The expected idiosyncratic skewness of firms' profit (EISP) has negative predictive power for subsequent stock returns.•The finding is robust to controlling for well-documented firm characteristics and risk factors.•Rational risk-based explanations as well as the limits to arbitrage and lottery preference hypotheses are examined.•The effect in the Chinese market is probably driven by the immaturity of investors.