The Distress Anomaly
Why You Shouldn’t Invest in Companies that Are Going Bankrupt
According to academic finance theory, riskier investments should earn higher returns. Following this logic, since bankruptcy is a big risk, investing in companies with a high risk of bankruptcy should earn big returns.
Thirty years ago, that type of thinking was Nobel Prize material. These days, however, the name of the game is identifying so-called “anomalies”—where the real world doesn’t perform in line with the theories of the previous generation of scholars.
In a groundbreaking 2008 paper, now cited by almost 2,000 other papers, Harvard professor John Campbell documented a very important anomaly: “since 1981, financially distressed stocks have delivered anomalously low returns.” Despite theorizing by such eminent scholars as Merton and Fama and French, Campbell showed that, historically, investors had not earned higher returns for investing in companies with a higher probability of bankruptcy. Figure 1 shows how equity returns decline as financial distress increases.
Figure 1: Alphas of Distressed Stock Portfolios
Source: Campbell et al. 2006. The figure plots the annualized mean excess return over the market, CAPM alpha, and Fama-French three-factor alpha for the 10 distress-risk-sorted portfolios from 1981 to 2003. The authors measure financial distress by sorting stocks according to failure probabilities developed from a logit regression of predictor variables from bankruptcy data spanning 1963–1998.
Campbell found that the low returns of distressed stocks “hold in all size quintiles but are particularly strong in smaller stocks.” Notably, Campbell’s work is “inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress.” In other words, small, cheap equities do not owe their outperformance to any associated increases in distress. This finding has also been replicated internationally.
We believe the same phenomenon holds true in bond markets. Investors owning higher-yielding, lower-rated bonds end up earning lower total returns than they would have buying lower-yielding, higher-rated bonds. This relationship is driven by default losses that overcome the higher coupon payments associated with increasing levels of distress. We call this phenomenon “Fool’s Yield’,” which is demonstrated in Figure 2.
Figure 2: Risk & Return Characteristics of Corporate Bonds 1997–2019
Source: FRED, ICE BofAML Indices. January 1997 to March 2019.
There are a variety of ways to measure distress risk from simple variables like debt/assets, debt/EBITDA or third-party models like credit ratings. Regardless of which metric you use, we believe the data supports one clear conclusion for both stocks and bonds: avoid companies with a high risk of bankruptcy.
There is, however, one important nuance. Stanford professor Joseph Piotroski—one of the seminal thinkers on the use of accounting data in investing—has found that Campbell’s work is not a reason to avoid cyclical stocks whose probability of default might increase during a recession. These types of cyclicals have, in fact, earned higher returns.
We believe the sum of this work implies that investors should be wary of companies at a high risk of distress, in good times and in bad. Both equities and bonds exhibit the same strong result: returns go down as bankruptcy risk increases.