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Prior research documents that asset growth is negatively associated with future firm performance. In contrast, we show that growth financed by product market stakeholders (i.e., “operating growth”) is positively associated with future firm performance. Investors and security analysts underestimate the positive effects of operating growth on future performance, resulting in return predictability and overly pessimistic earnings forecasts for firms with high operating growth. Future stock returns largely concentrate around subsequent earnings announcements with declining magnitudes, consistent with the error-in-expectation explanation. Results from cross-sectional tests further support the hypothesis that operating growth signals high future performance but investors underreact to it.
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