Decomposition of risk for small size and low book-to-market stocks

• Published in: Journal of asset management Vol. 25; no. 1; pp. 96 - 112
• Main Authors: Kale, Arati, Kale, Devendra, Villupuram, Sriram
• Format: Journal Article
• Language: English
• Published: London Palgrave Macmillan UK 01.02.2024; Palgrave Macmillan
• Subjects: Abnormal returns; Accounting; Capital assets; Cash flow forecasting; Economics and Finance; Finance; Financial Services; Net income; Original Article; Proxies; Risk Management; Stocks; Long–short portfolio; 3-Factor model; G40; G1; Distress risk; G10
• ISSN: 1470-8272; 1479-179X
• DOI: 10.1057/s41260-023-00329-w

We investigate whether the size and book-to-market ratio fully capture the financial distress risk of firms within the small/low group of stocks. Size and BE/ME ratio struggle to explain the distress risk of small/low firms because they are usually analyzed together with small declining firms in factor analysis models. Using the Fama–French 3 factor model, we identify small (size) and low (BE/ME ratio) stocks and sort them further based on their financial distress risk. Using thirteen different proxies of financial distress risk, we find that the significant intercept of the Fama–French 3 factor model is statistically insignificant for firms with low financial distress risk. We also show that the low-high portfolios earn statistically significant positive returns when sorting on distress risk. Our results are robust to changes in the distress risk proxy and sorting methods (terciles/quintiles/deciles). We further find that cash flow-based proxies of distress risk generate the highest abnormal returns, followed by analyst coverage and net income.