Decomposition of risk for small size and low book-to-market stocks

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.