The answer is: No. Stocks with predictably higher fraud risk earn significantly lower stock market returns going forward. Based on an out-of-sample estimation of individual firms' fraud risk, we find a significantly negative return premium for firms with the highest fraud propensity. A portfolio investing in firms with the lowest fraud probability and shorting firms with the highest fraud probability yields abnormal returns of more than 10 percent per year. This result is robust to various asset pricing models that control for differences in firms' quality, liquidity, downside risk, or investor preferences. Our results suggest that the market does not efficiently price corporate fraud risk. This finding is puzzling, because limits of arbitrage do not seem to explain our results. Furthermore, abnormal returns are higher after periods of high sentiment, suggesting that the return patterns documented here constitute an anomaly.
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