Leverage, Financial Distress and the Cross-Section of Stock Returns Thomas J. George University of Houston and   Chuan-Yang Hwang Nanyang Business School Nanyang Technological University December, 2006

Motivation Almost every textbook shows that raw return and equity beta increase with leverage. Does leverage affect return once equity beta has been controlled for? Or equivalently, does leverage affect risk adjusted return? Bhandari (1988) showed that leverage affect return even after controlling for CAPM equity beta. He explains this result as CAPM is not a right asset pricing model. More and more evidences have shown that CAPM is not a good asset pricing model. Fama-French three factors model has become a popular alternative. Will leverage affect FF risk-adjusted return? .

Financial Distress Risk Puzzle Dechev (1998) shows that firms with higher financial distress risk earns lower return and concludes that financial distress risk is not a systematic risk. Griffin-Lemmon (2002) show that the distress puzzle mainly resides in stocks with low book to market value. Investors mis-pricing is the cause of the distress risk puzzle.

Main Findings Leverage is negatively related to the future return. No distress risk puzzle once we control for leverage. Our results are not due to mis-pricing. Low leverage firms are riskier than high leverage firms and they fare poorly in financial distress situation. Book-to-market factor alone does not capture how bad things can get for some firms when times are tough. Book to market captures the operating distress risk , while leverage captures the financial distress risk. Both risks are priced. We construct a leverage factor and show that the leverage risk premium is larger than the book to market risk premium for small size and low book to market FF portfolio. This is consistent with low book to market firms have more intangible assets hence larger financial distress risk.

Data and Methodology Monthly data for all NYSE, AMEX and NASDAQ firms covered by CRSP from 1965 through 2003. Leverage is measured as the ratio of book value of total debt to book value of total asset.

Data and Methodology (cont’d)

Data and Methodology (cont’d)

Data and Methodology (Cont’d)

Correlation of variables

Table 3 Leverage and O-Score Raw Returns

Table 3 .1 Leverage and O-Score Risk Adjusted Returns

The hypotheses for the negative leverage effect Pricing Error: Even the firms with high (low) debt have suffered from low (experienced high) return in the past few years, investors may be still too optimistic (pessimistic) about the earnings. Risk: Low (high) debt firms have high return because they are inherently riskier (less risky), and they fare much worse (better) in distress situation.

Tests of the Pricing Error Hypothesis for the Negative Leverage Effect Prediction of Pricing Error Hypothesis: There should be a more positive (negative) earning surprise, hence a higher (lower) abnormal earning announcement, for low (high) leverage firms. We follow La Porta et al (1997) methodology which they use to test the pricing error hypothesis for the book to market effect

Tests of the Pricing Error Hypothesis for the Negative Leverage Effect We follow La Porta et al (1997) methodology which they use to test the pricing error hypothesis for the book to market effect. We benchmark each earning announcement return by the firm with median book-to market in the same decile as the announcer. Every June, we sort firms independently into five groups by O-score and three groups by debt/asset ratio (top 30%, middle 40% and bottom 30%), and form portfolios based on these groupings. For each firm, we then compute the average cumulative three day abnormal return over the four quarterly announcement returns following portfolio formation and annualize this number by multiplying by four.

Table 7 Three-Day Cumulative Abnormal Return around Earnings Announcements for Portfolios Sorted on Debt/Asset and O-Score Debt/Asset Number of stocks O-Score L M H H-L P-value -0.62 -0.27 2.79 3.42 0.025 417 141 2 -0.52 -0.07 0.13 0.64 0.181 187 345 47 3 0.19 0.23 0.03 0.950 87 301 165 4 -0.10 -0.12 -0.34 -0.24 0.744 56 199 284 -0.54 -0.59 -0.30 0.24 0.789 41 110 289

Evidences of High Debt firms Are Less Risky The range of the return from high to low distress is smaller for the high debt firms. STD of the return on asset and on equity are smaller for high debt firms. STD is calculated under the assumption that return on asset (or equity) follows a seasonal random walk with drift.

Company attributes (cont’d)

Table 12.1 Leverage and Oscore by Subperiod Risk Adjusted Returns

Four-Factor Model We create a leverage factor (LEV) in addition to FF three factors (Market, SMB, HML) to form a four-factor pricing model. Since FF (1993) also hypothesized that their HML captures financial distress risk, can our LEV displace their HML? We use four-factor model to explain the return of FF 100 portfolios. We find that most of the FF 100 portfolios have significant loadings on both LEV and HML factors. This indicates both LEV and HML risks are priced.

Operating Distress Risk Vs. Financial Distress Risk Operating distress risk measures the difficulty in reversing physical investment in bad economy, hence high book to market firms have high operating distress risk. Financial distress risk measure the loss of asset value when in financial distress. We have shown low leverage firms have high financial distress risk. HML captures operating distress risk, while LEV captures financial distress risk. This can explain the LEV risk premium are high for small size and low book to market value firms since these firms have more intangible assets hence larger financial distress risk.

Conclusion We document a negative leverage effect : Book leverage is negatively related to both raw return and risk adjusted return. There is no distress risk puzzle after controlling for the leverage. The negative leverage effect can not be explained by to pricing error; Instead it can be explained as low leverage firms have higher financial distress cost. Low leverage firms indeed have higher financial distress cost; we show they fare much worse in distress.

Conclusion We create a leverage factor that capture financial distress risk which helps explain the FF portfolio return that book to market factor does not explain. The leverage factor risk premium is much larger for small size and small book to market firms. This is consistent with the fact that low book to market firms have more intangible assets hence have larger financial distress risk