The distress risk anomaly of substantial stock underperformance of high–credit risk firms is examined over two decades in this global study. Concentrated among small-cap stocks in developed markets, the pattern is poorly explained by risk-based factors. It seems instead to fit a behavioral interpretation of investor overconfidence resulting in temporary mispricing from underreaction to news.
How Is This Research Useful to Practitioners?
The authors reinterpret the longstanding equity-pricing anomaly of distress risk, under which the stock of firms highly exposed to credit risk substantially underperform. Their findings are corroborated across a broad span, with a comprehensive global sample covering 20+ years. The price effect is concentrated among small companies in North American and European developed markets, offering gains of 40 bps to 50 bps from a portfolio arbitrage that finances a short position in a market’s most-distressed small-cap decile with a long position in the least-distressed stocks. This return is comparable to that from a simple momentum strategy over the matching period and persists for several months to a year after portfolio formation.
After ruling out a simple historical explanation (i.e., that the effect is an artifact of a mid-1980s US bankruptcy wave), the authors discard risk-based justifications—for example, risks with weak creditor protections and equityholder-expropriating debtholders. The risks associated with small firms are well reflected in rational models.
Rather, as a warning to investors about potential behavioral blind spots, overconfidence is highlighted as a primary driver. Slow adaptation by investors to impending bad news—for example, when initial opinions are formed in bull markets and the stocks are aggressively favored—leads to only temporary mispricing and exacerbated price declines in subsequent downtrends. And when it rains, it pours, with performance being especially poor for firms after recent announcements of bad news.
How Did the Authors Conduct This Research?
Common stock returns and accounting variables for January 1992–June 2013 across 38 developed and emerging markets are drawn from Compustat. In all, the sample includes 44,930 companies, with about half from developed markets.
Credit risk is based on Moody’s KMV database of expected default frequencies (EDFs), which are ex ante estimates based on Merton’s (Journal of Finance 1974) model. EDF portfolios are constructed with all firms aggregated within a given decile monthly and globally to eliminate bias in terms of developed versus developing market effects.
Four-factor model regressions are run to determine relative returns across risk categories. Results are derived for the entire sample and stocks of large-cap versus small-cap firms, both worldwide and disaggregated by region/market. To evaluate risk-based explanations, the authors test high-distress stocks for low systematic risk and differentiated credit profiles. Cross-sectional effects of creditor protections are checked and mispricing (if any) of risk assessed.
Abstractor’s Viewpoint
The authors make a thorough and carefully reasoned presentation on an asset-pricing irregularity first identified about two decades ago. But from the possibly more pragmatic perspective of stock investors seeking potential trading opportunities, it is unclear whether the findings will be especially compelling and/or revelatory. That high–credit risk firms can end up with especially poor stock performance is not particularly surprising. This segment probably would not draw significant attention, given that financial weaknesses are customarily undesirable for both stocks and bonds.
One possible weakness of the study is that the authors use an international measure of individualism based on a 1960s/1970s psychological study of IBM employees as a proxy for overconfidence, with no specific metric on overconfidence developed for investors.
Nonetheless, the results show that it is unwise to avidly reach for prospecting shortcuts because the potentially attractive (and known) anomaly of small stock outperformance is positioned for disappointment when combined with a weak corporate financial profile. And overconfidence can result in ultimately unprofitable exposure to credit-challenged firms but likely not because of the hypothesized cultural characteristic of individualism. Developed market investors may have fewer investment opportunities for extended and robust cash flow growth, so they may be more inclined to exaggerate the prospects of available targets. It seems more persuasive to focus explanations on actual investment processes instead of generic background conditions.