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Financial Management, 2008, Volume 37, Number 3, Pages 461-484
Does Financial Distress Risk Drive the Momentum Anomaly?
This paper brings together the evidence on two asset pricing anomalies – continuation of
prior returns (momentum) and the market mispricing of distressed firms, using UK data. Our
analysis demonstrates both these effects are driven by market under reaction to financial distress
risk. In particular, we find momentum is proxying for distress risk, and is largely subsumed by
our distress risk factor. We also find, as with U.S. studies, no evidence that size and B/M effects
in stock returns are linked to financial distress.
Vineet Agarwal is a(n) Lecturer at the Cranfield School of Management, Bedford MK43 0AL
UK. Richard Taffler is a(n) Professor at the Management School, University of Edinburgh,
This paper has benefited, in particular, from the comments of the anonymous referee as well as,
among others, Michael Boldin, Jonathan Crook, Weimen Liu, Craig Nicholls, Norman Strong
and Sudi Sudarsanam, and participants at the annual meetings of the Financial Management
Association, American Accounting Association, European Financial Management Association,
British Accounting Association, and INQUIRE UK, and research seminars held at Lancaster
University, University of Manchester and Cass Business School.
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I. Introduction
Market pricing of distress risk has attracted a lot of academic interest since the financial
distress factor hypothesis of Chan and Chen (1991) and Fama and French (1992) attributed
higher returns to small stocks and value stocks to firms being relatively distressed.
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If risk of
financial distress is pervasive and missed by the standard CAPM, we would observe either a
positive or negative risk premium on distressed stocks. A positive risk premium would exist if
distress risk is correlated with other factors, such as size and book-to-market (B/M), but is
missed by the market factor or the market over reacts to bankruptcy risk. A negative risk
premium would be observed if investors under react to risk of failure leading to the stock prices
of such firms not being discounted sufficiently or due to lower systematic risk. If the market does
under react to bankruptcy risk, distressed firms will have low prior-year returns. These low
returns will continue for some time into the future generating a negative financial distress risk
premium and continuation of prior returns (momentum). This paper specifically tests whether
momentum proxies for distress risk in the UK. Significantly, such a financial distress explanation
for the continuation of the prior returns anomaly has not been explored in the literature to date.
The existence of medium-term continuation of stock returns (momentum), the most
challenging of all anomalies (Fama, 1998), is well established (Jegadeesh and Titman, 1993,
2001; Liu, Strong, and Xu, 1999). Jegadeesh and Titman (1993, 2001) and other studies (Daniel
and Titman, 1999; Hong, Lim, and Stein, 2000) argue momentum is driven by market under
reaction to information. According to Barberis, Shleifer, and Vishny (1998), investors are slow
to update their beliefs in response to new public information leading to under reaction. This
under reaction generates positive autocorrelation in stock returns. Beaver (1968) is one of the
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Following Fama and French (1993, 1995), we define the term distress factor as representing individual firm
financial distress. As such, we use the terms financial distress and bankruptcy risk interchangeably.
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first to demonstrate that subsequently bankrupt firms under perform the market for up to four
years prior to bankruptcy, and particularly during the last year. This suggests that the market is
anticipating, but not fully incorporating (i.e., under reacting to), the deteriorating financial health
of a firm. Distressed firms, therefore, experience lower past realized returns. Hong et al. (2000)
and Lesmond, Schill, and Zhou (2004) find most of momentum profits come from the returns
continuation of poor performers. Campbell, Hilscher, and Szilagyi (2006) indicate that prior-year
return is a significant predictor of subsequent bankruptcy. This implies momentum is capturing
financial distress risk, an important issue not directly addressed in the existing literature. Hence,
if the market under reacts to the poor solvency position of firms, we should find that: 1)
distressed stocks earn lower returns than non-distressed stocks as the market slowly realizes its
error and drives down distressed stock prices, and 2) medium-term continuation of returns is
driven by the lower returns earned by distressed stocks.
The only other paper that focuses on the relation between momentum and credit risk is
Avramov, Chorida, Jostova, and Philipov (2007a) who demonstrate that momentum exists only
in poorly rated firms, and the under performance of poor credit risk firms is driven by the
continuation of low returns for losers. However, Avramov et al.’s (2007a) sample is restricted to
firms that have a credit rating (less than 30% of all firms), and they do not conduct any formal
cross-section tests of the relationship between credit risk and momentum. Surprisingly, the
authors also argue that credit ratings are not the same as default risk, which they suggest is better
proxied by leverage.
Linking size and B/M effects to financial distress is consistent with observed high failure
rates of small and value stocks as such stocks tend to earn higher returns (Fama and French,
1992, 1993; Strong and Xu, 1997). On this basis, we would expect that: 1) distressed stocks earn
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higher returns than non-distressed stocks, and 2) there is no size or value effect in stock returns
once we control for distress risk.
There is substantial evidence that distressed firms earn lower returns than non-distressed
firms. Dichev (1998) finds firms with a high probability of bankruptcy, on average, under
perform low risk firms by 1.2% per month over the period 1980-1995. He concludes such
evidence is hard to reconcile with the pricing of risk in efficient markets and mispricing is a
more likely explanation for such anomalous results. Similarly, Lamont, Polk, and Saa-Requejo
(2001), using the Kaplan and Zingales (1997) financial constraints index, find that even though
financially constrained firms have characteristics associated with higher returns (high leverage,
high B/M, high prior-year returns), they earn lower returns than non-constrained firms. Though
their index does not directly measure financial distress, financially constrained firms are more
likely to face financial distress than non-constrained firms. Griffin and Lemmon (2002),
Ferguson and Shockley (2003), and Campbell et al. (2006) also find distressed firms earn lower
returns. In contrast, Vassalou and Xing (2004), adopting a contingent claims approach, find
distressed firms earn higher returns. However, Garlappi, Shu, and Yan, (2006), using the related
EDF measure provided by Moody’s KMV, find no significant difference in returns between
distressed and non-distressed firms. Nonetheless, none of these studies explore a potential link
between the distress risk and the medium-term continuation of prior returns market anomalies,
the original contribution of this paper.
We employ a widely used accounting ratio based z-score model as a proxy for default
risk as with Dichev (1998), Griffin and Lemmon (2002), and Ferguson and Shockley (2003).
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The main results of our paper are: 1) consistent with a market under reaction story - distress risk
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Agarwal and Taffler (2007a) suggest that the z-score measure we use performs at least as well as the contingent
claims approach in predicting financial distress.
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appears to have a negative risk premium, 2) the momentum effect in stock returns is proxying for
distress risk and is subsumed by a financial distress factor, and (3) in contrast to the arguments of
Fama and French (1993, 1995), among others, and consistent with Dichev (1998) and Campbell
et al. (2006), there is no evidence to suggest size and B/M are capturing bankruptcy risk.
The paper is organized as follows: Section II provides our hypotheses, data, and method,
Section III presents our results using time series regressions, and Section IV provides our results
using cross-section regressions. Section V summarizes and discusses our findings.
II. Hypotheses, Data, and Method
This section presents our hypotheses, discusses our sample selection and data, and
describes how we use the Fama and French (1993) three-factor model and Fama and MacBeth
(1973) method to test our hypotheses.
A. Hypotheses
This paper sets out to determine whether three key market anomalies, size, B/M, and
momentum, can be explained by firm financial distress risk. Chan and Chen (1991) and Fama
and French (1992), among others, argue that smaller firms and high B/M firms are relatively
distressed. Higher returns on such firms are a compensation for this risk (the financial distress
factor hypothesis). On this basis, we expect that: 1) controlling for size (B/M), distressed stocks
will earn a higher return than non-distressed stocks and 2) controlling for distress risk, low
market capitalization (high B/M) firms will not out perform high market capitalization (low
B/M) stocks.
To test the distress factor proposition formally, we establish the following null
hypotheses:
