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Credit Ratings and Stock Return Anomalies

Posted in Big Ideas, Fundamental Valuation, Momentum Investing, Value Premium

Does designated creditworthiness, closely related to riskiness, drive the performance of many widely acknowledged stock return anomalies? In the April 2010 revision of their paper entitled “Anomalies and Financial Distress”, Doron Avramov, Tarun Chordia, Gergana Jostova and Alexander Philipov use portfolio sorts and regressions to investigate the relationship between financial distress (low credit ratings and downgrades) and profitability for trading strategies based on: stock price momentum, earnings momentum, credit risk, analyst earnings forecast dispersion, idiosyncratic volatility, asset growth, capital investments, accruals and value. Using data for broad samples of U.S. stocks (limited by extensive information requirements) spanning October 1985 through December 2008, they conclude that:

  • Profitability of strategies based on price momentum, earnings momentum, credit risk, analyst earnings forecast dispersion, idiosyncratic volatility and capital investments derives predominantly from short positions in firms with poor credit during deteriorating credit conditions.
    • Profitability of these anomalies comes entirely from firms rated BB+ or lower, representing only 9.7% of sample market capitalization. However, the anomalies are reasonably robust among all size groups.
    • Profitability comes mostly from 12-month intervals bracketing credit rating downgrades.
  • The asset growth anomaly exhibits similar patterns, except for very small-capitalization stocks with low credit ratings and large-capitalization stocks with medium credit ratings.
  • Findings do not apply to the accruals and value anomalies.
    • The accruals anomaly (a result of management discretion concerning the gap between net profit and operating cash flows) is robust for firms of both high and low credit risk, and across deteriorating, stable and improving credit conditions.
    • The value anomaly appears to derive from long positions in low-rated firms that survive financial distress, mostly during stable or improving credit conditions.
  • Firms with low credit ratings tend to have smaller market capitalization, lower stock price, higher market sensitivity (beta), higher sensitivity to the size factor, lower dollar trading volume, lower liquidity, higher leverage, lower institutional ownership and higher uncertainty about future earnings.
  • Credit rating downgrades do not cluster in bull or bear markets, or in recessions or expansions.
  • The poor performance of distressed firms consistently surprises analysts, resulting in large negative earnings surprises and large negative forecast revisions.
  • Stocks of firms with low credit ratings tend to be difficult to short (few shares available for borrowing) and illiquid, generally confounding exploitation of related anomalies.

In summary, evidence indicates that many (but not all) well-known stock return anomalies derive their profitability from short positions in firms with low credit ratings during deteriorating credit conditions, with shorting constraints and illiquidity limiting exploitation.

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