Is there a jackpot in distressed equity?

Are distressed stocks more likely to generate returns above 100%?

We have done a series of posts on the returns of distress stocks. We have discussed the existence of a distress discount, and we have concluded that loading a portfolio with distress risk may not be an ideal strategy because this risk is not compensated with high returns.

Today, we look at distress risk from a different angle. We investigate whether distress risk is correlated with jackpot returns. That is to say whether firms with high distress risk are more likely to generate extraordinarily high returns (>100%).

Our discussion of equity returns and distress risk has focussed on average expected returns. This reflects the standard approach taken in asset pricing theory and tests, which itself is based on the assumption that investors are risk averse, and optimize their portfolios in a mean-variance framework.

But, what if investors were risk lovers and played the market as if they were gambling at a casino? Risk lovers are seek extremely skewed payoffs, and may be willing to take an investment that carries a negative expected return, but that occasionally pays a jackpot return.

In this post, we will focus on whether jackpot returns are more common in distressed stocks. In the next posts, we will investigate who owns jackpot stocks.

The figure below is from Conrad, Kapadia and Xing (2014) and it shows that the probability of hitting a jackpot tends to be higher during recessions. We know that distress risk is also higher in a recession. This is the first hint that distress and jackpot returns may go hand in hand.

The table below (also from the same authors) investigates the matter in more detail. Firms are sorted according to the probability of default computed using the model in Campbell, Hilscher, and Szilagyi (2008). A higher number from 1 to 10 means a higher probability of default.

The row “Excess return” confirms what we already know from previous posts: average returns are lower for the portfolios with a higher probability of distress. Weird but true. The “Four-factor alpha” is also negatively related to returns.

Now, examine the row “Arithmetic returns > 100%.” In the portfolio with the lowest probability of default, the probability of a return that exceeds 100% is just 1.4%. Instead, in the portfolio with the highest probability of distress, the probability of a 100% return is 9.1%.

While average returns decrease with distress, the probability of a jackpot return increases with distress. The lesson is: if you are thirsty for a gamble, look among distressed stocks!

References

• 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.