Understanding the Distress Puzzle: Surprises in the Pre-Delisting Period

Abstract

In this study, I decompose realized returns into ex ante expected returns (as proxied by the implied cost of capital) and unexpected returns. I show that the negative cross-sectional relation between distress risk and stock returns documented in previous studies is driven by the increasingly low ex post unexpected returns and the increasingly high distress risk in the pre-delisting period – the two-year period prior to a firm’s delisting due to financial distress. After controlling for the firm-months in the pre-delisting period, which constitutes only 0.3% of total market capitalization or 3%-5% of NYSE/AMEX/Nasdaq firm-months, distress risk is positively related to ex post realized returns. The finding is robust to a range of distress risk measures, size, book-to-market ratio, momentum, leverage, and short-term reversal. Ex ante, investors expect high earnings per share (EPS) and stock returns in firms with high distress risk, but they are surprised by the lower-than-expected EPS and returns (ex post) in the pre-delisting period. The negative surprises concentrate around earnings announcements and the delisting month when investors correct their valuation errors about distressed firms’ future prospect. Overall, realized returns are similar to ex ante expected returns, except in the pre-delisting period. This divergence has implications in asset-pricing tests.

Keywords: Distress risk, delisting, bankruptcy, expected return, implied cost of capital, asset pricing anomaly, earnings announcement

JEL Classification: G12, G14, G33