Is it worth investing in distressed stocks?

We investigate whether investing in stocks that are close to default generates a premium

Hundreds of firms are going bust these days. Since the beginning of the pandemic 157 companies with liabilities of more than $50m have filed for bankruptcy. The rate at which defaults are occurring is faster than in the crises of 2002 and 2009.

From the point of view of an investor, this might not be all bad news. Bankruptcies destroy value, but also create investment opportunities. The question is: is it worth investing in distressed stocks? Should one scout for fallen angels that may come back to life like a phenix?

Asset pricing theory predicts that those who dare to bear risk shall be rewarded with higher returns. Thus, if you buy a stock that is close to bankruptcy or that has already filed for bankruptcy, you should expect higher average returns on your investment. This would be your reward for taking such risk.

Because you can buy distressed stocks for peanuts, a possible strategy is to buy shares in many distressed stocks in the hope that at least a few will make a comeback. If asset pricing theory is correct, the returns you make on the come backs will more than make up for the losses on the firms that end up in oblivion.

That is the theory. Unfortunately, the evidence shows that this is far from true. The data show that investing in distressed firms yields low returns on average, despite the high risk involved. Put it in another way, distress stocks carry a discount rather than a premium vis-à-vis the market.

The fact that distressed stocks yield on average a lower return than healthy stocks is known as the financial distress puzzle.

Below is a figure by Eisdorfer and Misirli (2020). It reports the performance of a zero-investment value-weighted portfolio (HMD) of buying the most healthy stocks portfolio and selling the most distressed stocks portfolio, and holding this portfolio for one month. The figure plots the value of a $1 investment in the HMD portfolio (dashed line) and in the market portfolio in excess of the risk-free asset (RmRf, solid line) from January 1975 to December 2017.

If there was a distress premium, whereby investors are compensated for bearing distressed risk, the HMD portfolio should generate negative returns on average. Instead, the HMD portfolio performs strongly during most of the last four decades, suggesting a distress discount rather than a premium. Investing in the HMD portfolio in 1980 would have yielded a stronger performance than the market all the way until the early 2000s.

The shaded grey areas represent the bear market months. Interestingly, during the bear markets of the dot.com burst and of the great financial crisis, HMD reported a terrible performance. Is there something into the idea of timing the HMD strategy? It appears that we should invest in distress stocks during a bear market.

References

• Anginer, D. and Yıldızhan, Ç., 2018. Is there a distress risk anomaly? Pricing of systematic default risk in the cross-section of equity returns. Review of Finance, 22(2), pp.633-660.

• Aretz, K., Florackis, C. and Kostakis, A., 2018. Do stock returns really decrease with default risk? New international evidence. Management Science, 64(8), pp.3821-3842.

• Campbell, J.Y., Hilscher, J. and Szilagyi, J., 2008. In search of distress risk. The Journal of Finance, 63(6), pp.2899-2939.

• Conrad, J., Kapadia, N. and Xing, Y., 2014. Death and jackpot: Why do individual investors hold overpriced stocks?. Journal of Financial Economics, 113(3), pp.455-475.

• Eisdorfer, A. and Misirli, E.U., 2020. Distressed stocks in distressed times. Management Science, 66(6), pp.2452-2473.

• Friewald, N., Wagner, C. and Zechner, J., 2014. The cross‐section of credit risk premia and equity returns. The Journal of Finance, 69(6), pp.2419-2469.

• Gao, P., Parsons, C.A. and Shen, J., 2018. Global relation between financial distress and equity returns. The Review of Financial Studies, 31(1), pp.239-277.

• Garlappi, L. and Yan, H., 2011. Financial distress and the cross‐section of equity returns. The journal of finance, 66(3), pp.789-822.

• Kapadia, N., 2011. Tracking down distress risk. Journal of Financial Economics, 102(1), pp.167-182.

• Pandemic triggers wave of billion-dollar US bankruptcies https://www.ft.com/content/277dc354-a870-4160-9117-b5b0dece5360