IDEAS home Printed from https://ideas.repec.org/a/pal/assmgt/v25y2024i1d10.1057_s41260-023-00329-w.html
   My bibliography  Save this article

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

Author

Listed:
  • Arati Kale

    (Providence College)

  • Devendra Kale

    (University of Rhode Island)

  • Sriram Villupuram

    (University of Texas at Arlington)

Abstract

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.

Suggested Citation

  • Arati Kale & Devendra Kale & Sriram Villupuram, 2024. "Decomposition of risk for small size and low book-to-market stocks," Journal of Asset Management, Palgrave Macmillan, vol. 25(1), pages 96-112, February.
    • Handle: RePEc:pal:assmgt:v:25:y:2024:i:1:d:10.1057_s41260-023-00329-w
    DOI: 10.1057/s41260-023-00329-w
    as

    Download full text from publisher

    File URL: http://link.springer.com/10.1057/s41260-023-00329-w
    File Function: Abstract
    Download Restriction: Access to the full text of the articles in this series is restricted.
    File URL: https://libkey.io/10.1057/s41260-023-00329-w?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    2. Lakonishok, Josef & Shleifer, Andrei & Vishny, Robert W, 1994. "Contrarian Investment, Extrapolation, and Risk," Journal of Finance, American Finance Association, vol. 49(5), pages 1541-1578, December.
    3. Harrison Hong & Terence Lim & Jeremy C. Stein, 2000. "Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies," Journal of Finance, American Finance Association, vol. 55(1), pages 265-295, February.
    4. X. Frank Zhang, 2006. "Information Uncertainty and Stock Returns," Journal of Finance, American Finance Association, vol. 61(1), pages 105-137, February.
    5. John M. Griffin & Michael L. Lemmon, 2002. "Book‐to‐Market Equity, Distress Risk, and Stock Returns," Journal of Finance, American Finance Association, vol. 57(5), pages 2317-2336, October.
    6. Novy-Marx, Robert, 2013. "The other side of value: The gross profitability premium," Journal of Financial Economics, Elsevier, vol. 108(1), pages 1-28.
    7. John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2008. "In Search of Distress Risk," Journal of Finance, American Finance Association, vol. 63(6), pages 2899-2939, December.
    8. Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, vol. 43(3), pages 617-637, July.
    9. James L. Davis & Eugene F. Fama & Kenneth R. French, 2000. "Characteristics, Covariances, and Average Returns: 1929 to 1997," Journal of Finance, American Finance Association, vol. 55(1), pages 389-406, February.
    10. Assaf Eisdorfer & Amit Goyal & Alexei Zhdanov, 2012. "Misvaluation and Return Anomalies in Distress Stocks," Swiss Finance Institute Research Paper Series 12-12, Swiss Finance Institute.
    11. Edward I. Altman, 1968. "Financial Ratios, Discriminant Analysis And The Prediction Of Corporate Bankruptcy," Journal of Finance, American Finance Association, vol. 23(4), pages 589-609, September.
    12. Ohlson, Ja, 1980. "Financial Ratios And The Probabilistic Prediction Of Bankruptcy," Journal of Accounting Research, Wiley Blackwell, vol. 18(1), pages 109-131.
    13. Harlan Platt & Marjorie Platt, 2002. "Predicting corporate financial distress: Reflections on choice-based sample bias," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 26(2), pages 184-199, June.
    14. Beaver, Wh, 1966. "Financial Ratios As Predictors Of Failure - Reply," Journal of Accounting Research, Wiley Blackwell, vol. 4, pages 123-127.
    15. Merton, Robert C, 1987. "A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
    16. De Bondt, Werner F M & Thaler, Richard H, 1987. "Further Evidence on Investor Overreaction and Stock Market Seasonalit y," Journal of Finance, American Finance Association, vol. 42(3), pages 557-581, July.
    17. Laurel A. Franzen & Kimberly J. Rodgers & Timothy T. Simin, 2007. "Measuring Distress Risk: The Effect of R&D Intensity," Journal of Finance, American Finance Association, vol. 62(6), pages 2931-2967, December.
    18. John Lintner, 1965. "Security Prices, Risk, And Maximal Gains From Diversification," Journal of Finance, American Finance Association, vol. 20(4), pages 587-615, December.
    19. Banz, Rolf W & Breen, William J, 1986. "Sample-Dependent Results Using Accounting and Market Data: Some Evidence," Journal of Finance, American Finance Association, vol. 41(4), pages 779-793, September.
    20. Daniel, Kent & Titman, Sheridan, 1997. "Evidence on the Characteristics of Cross Sectional Variation in Stock Returns," Journal of Finance, American Finance Association, vol. 52(1), pages 1-33, March.
    21. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    22. Penman, SH, 1996. "The articulation of price-earnings ratios and market-to-book ratios and the evaluation of growth," Journal of Accounting Research, Wiley Blackwell, vol. 34(2), pages 235-259.
    23. Basu, Sudipta, 1997. "The conservatism principle and the asymmetric timeliness of earnings," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 3-37, December.
    24. Beaver, Wh, 1966. "Financial Ratios As Predictors Of Failure," Journal of Accounting Research, Wiley Blackwell, vol. 4, pages 71-111.
    25. Opler, Tim C & Titman, Sheridan, 1994. "Financial Distress and Corporate Performance," Journal of Finance, American Finance Association, vol. 49(3), pages 1015-1040, July.
    26. Chan, K C & Chen, Nai-Fu, 1991. "Structural and Return Characteristics of Small and Large Firms," Journal of Finance, American Finance Association, vol. 46(4), pages 1467-1484, September.
    27. Diamond, Douglas W. & Verrecchia, Robert E., 1987. "Constraints on short-selling and asset price adjustment to private information," Journal of Financial Economics, Elsevier, vol. 18(2), pages 277-311, June.
    28. Ilia D. Dichev, 1998. "Is the Risk of Bankruptcy a Systematic Risk?," Journal of Finance, American Finance Association, vol. 53(3), pages 1131-1147, June.
    29. Michael C. Jensen, 2005. "Agency Costs of Overvalued Equity," Financial Management, Financial Management Association, vol. 34(1), Spring.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Eero Pätäri & Timo Leivo, 2017. "A Closer Look At Value Premium: Literature Review And Synthesis," Journal of Economic Surveys, Wiley Blackwell, vol. 31(1), pages 79-168, February.
    2. Adam Zaremba & Jacob Koby Shemer, 2018. "Price-Based Investment Strategies," Springer Books, Springer, number 978-3-319-91530-2, June.
    3. Stefan Nagel, 2013. "Empirical Cross-Sectional Asset Pricing," Annual Review of Financial Economics, Annual Reviews, vol. 5(1), pages 167-199, November.
    4. Amit Goyal, 2012. "Empirical cross-sectional asset pricing: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 3-38, March.
    5. Idrees, Sahar & Qayyum, Abdul, 2018. "The Impact of Financial Distress Risk on Equity Returns: A Case Study of Non-Financial Firms of Pakistan Stock Exchange," MPRA Paper 85346, University Library of Munich, Germany.
    6. Boubaker, Sabri & Hamza, Taher & Vidal-García, Javier, 2018. "Financial distress and equity returns: A leverage-augmented three-factor model," Research in International Business and Finance, Elsevier, vol. 46(C), pages 1-15.
    7. John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2008. "In Search of Distress Risk," Journal of Finance, American Finance Association, vol. 63(6), pages 2899-2939, December.
    8. Juhani T. Linnainmaa & Michael R. Roberts, 2016. "The History of the Cross Section of Stock Returns," NBER Working Papers 22894, National Bureau of Economic Research, Inc.
    9. de Groot, Wilma & Huij, Joop, 2018. "Are the Fama-French factors really compensation for distress risk?," Journal of International Money and Finance, Elsevier, vol. 86(C), pages 50-69.
    10. David Hirshleifer, 2001. "Investor Psychology and Asset Pricing," Journal of Finance, American Finance Association, vol. 56(4), pages 1533-1597, August.
    11. Nedumparambil, Elizabeth & Bhandari, Anup Kumar, 2020. "Credit risk – Return puzzle: Evidence from India," Economic Modelling, Elsevier, vol. 92(C), pages 195-206.
    12. Avanidhar Subrahmanyam, 2010. "The Cross†Section of Expected Stock Returns: What Have We Learnt from the Past Twenty†Five Years of Research?," European Financial Management, European Financial Management Association, vol. 16(1), pages 27-42, January.
    13. Ebrahim, M. Shahid & Girma, Sourafel & Shah, M. Eskandar & Williams, Jonathan, 2014. "Rationalizing the value premium in emerging markets," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 29(C), pages 51-70.
    14. Avanidhar Subrahmanyam, 2008. "Behavioural Finance: A Review and Synthesis," European Financial Management, European Financial Management Association, vol. 14(1), pages 12-29, January.
    15. Michael Dempsey, 2015. "Stock Markets, Investments and Corporate Behavior:A Conceptual Framework of Understanding," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number p1007, June.
    16. Yinxia G. Nielsen , Caren, 2013. "Is Default Risk Priced in Equity Returns?," Knut Wicksell Working Paper Series 2013/2, Lund University, Knut Wicksell Centre for Financial Studies.
    17. M. Eskandar Shah & Sourafel Girm & R. Hudson, 2012. "Rationalizing the Value Premium under Economic Fundamentals in an Emerging Market," Working Papers 12010, Bangor Business School, Prifysgol Bangor University (Cymru / Wales).
    18. Nielsen, Caren Yinxia, 2011. "Hidden in the Factors? The Effect of Credit Risk on the Cross-section of Equity Returns," Working Papers 2011:38, Lund University, Department of Economics, revised 01 Oct 2016.
    19. van Dijk, Mathijs A., 2011. "Is size dead? A review of the size effect in equity returns," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3263-3274.
    20. YalçIn, Atakan, 2008. "Gradual information diffusion and contrarian strategies," The Quarterly Review of Economics and Finance, Elsevier, vol. 48(3), pages 579-604, August.

    More about this item

    Keywords

    Distress risk; Long–short portfolio; 3-Factor model;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G40 - Financial Economics - - Behavioral Finance - - - General

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:pal:assmgt:v:25:y:2024:i:1:d:10.1057_s41260-023-00329-w. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Sonal Shukla or Springer Nature Abstracting and Indexing (email available below). General contact details of provider: http://www.palgrave-journals.com/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.