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  • Writer's pictureOne Hat Research LLC

Finding Distress Risk

Prior evidence suggests a puzzling absence of compensating returns to the common stocks of highly-distressed companies. I examine three sets of highly-distressed common stocks - one set from the crash of the internet bubble (1999 to 2002), one from the financial crisis (2007 through 2008), and recent firms (2014 through 2019). I improve on prior work by demonstrating that my ex ante sorts actually do find highly-distressed firms, with ex post bankruptcy filing frequencies within one year of 44 percent, 36 percent, and 70 percent, respectively. Contrary to prior research, the returns to these samples are high, not anomalously low because even with a large frequency of total losses, returns are positively skewed by large outliers. Equally-weighted returns were 176 percent in the internet period, 200 percent in the crisis period, and 22 percent in the recent period. Market capitalization weighted investment in each period generates a 309 percent return in the internet period, 17 percent in the crisis period, and -33 percent in the recent period. The results suggest the need to re-examine the claim that distress risk is not priced.

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