Swedroe: Value Premium And Distress Risk

It’s hard to attribute the value premium to distress risk, Swedroe says.

While there are many studies demonstrating a link between the value premium and risk, the empirical evidence draws inconsistent conclusions on whether distress risk is a systematic risk factor that is priced in the cross section of stock returns.

There are studies that conclude that default risk is positively priced in the stock market, and that a large portion of the book-to-price effect can be attributed to default risk. For example, the 2010 study “Anomalies and Financial Distress” found that value strategies derive their profitability from taking long positions in high-credit-risk firms that are prone to distress risk, survive it and subsequently go on to earn high returns.

On the other hand, there are also papers that find a negative relation between distress risk and equity returns; stocks with higher levels of distress risk as measured by models earn low returns.

Thus, distress risk is therefore unlikely to account for the book-to-market effect; financially healthy, high book-to-market firms generate higher returns than firms that have less healthy financial statements; and returns of growth and value stocks are significantly negatively related to default risk.

The authors of the 2011 study, “Is the Value Premium Really a Compensation for Distress Risk,” covering the period 1991-2009, found that while value stocks are prone to somewhat higher levels of distress risk than the average stock, they also found that irrespective of whether they measured stocks’ probabilities on financial distress using accounting models, structural models, credit spreads or credit ratings, the value premium couldn’t be attributed to distress risk.

“We find no evidence whatsoever that default risk is a priced factor in the cross-section of equity returns. … our results are difficult to reconcile with a risk-based interpretation of the value anomaly and call for further research,” the authors concluded in the study.

Like the beer-commercial battle between “tastes great and less filling,” the debate between the behavioral and risk explanations for the value premium continues.

The problem for investors is that without a strong risk-based explanation, it creates doubt as to whether the value premium will persist. With that said, the momentum premium is generally considered to be based on behavior, not risk, and it’s been well known for decades and continues to persist well after publication of the research.