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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
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    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

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