The Small Growth and The Distress Anomalies: Two Sides of the Same Coin?

Abstract

We propose a unified explanation for two seemingly disparate empirical findings: the negative abnormal returns of distressed stocks, and of small growth stocks. Based on a counterintuitive result relating option prices to jump risk (Merton 76), we show via an investment valuation model that higher idiosyncratic risks of sudden corporate failure simultaneously generate lower expected returns and higher valuation ratios among smaller firms. Consistent with the model, high failure risk traits characterize small growth stocks, and a failure risk factor subsumes small growth returns while explaining several asset pricing anomalies.