When should you invest in distressed stocks?

We discuss the optimal timing of a strategy that invests in firms that are close to bankruptcy

In a previous post, we provided evidence that investing in distressed stocks does not repay investors for the risks that it carries.

Asset pricing theory suggests that loading a portfolio with risk should be rewarded with a risk premium. Instead, investing in distressed stocks carries a discount rather than a premium.

That is true on average. The question is: are there specific times when it is worth taking a gamble on distressed stocks?

Below is a figure by Eisdorfer and Misirli (2020). It reports the performance of a set of zero-cost long/short portfolios for 11 well-documented anomalies. A bull (bear) market is assumed if the cumulative market return during the past two years prior to portfolio formation is positive (negative). Investors observe an up-market month when the market turns positive during bear market conditions. The sample period is January 1975 to December 2017.

The top left panel reports the average returns of the 11 strategies over the full sample, while the other panels report the returns in other states of the market. Specifically we are interested in the strategy called “financial distress.”

The strategy “financial distress” is the performance of a zero-investment value-weighted portfolio of buying the most healthy stocks portfolio and selling the most distressed stocks portfolio, and holding this portfolio for one month.

What emerges from the data is that the “financial distress” strategy performs well in the full sample (January 1975 to December 2017), and especially well during bull markets. Instead it yields negative returns in bear markers and in the market rebound in a bear market.

In other words, distress stocks perform bad in general as compared to healthy stocks, and even more so bad in bull markets. Instead, distressed stocks perform better than healthy stocks in bear markets and in market rebounds.

What are the implications of this finding? You should invest in distressed stocks during market downturns.

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.