Here are a few recent articles by John Campbell of Harvard University.

The papers have a similar conclusion: “...[the results] are inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress.”

Quite an important statement/paper, which IMO requires some consideration. Here’s my take:

Concerns on methodology:

- 1. The paper limits the influence of outliers on the analysis through ‘winsorizing’ the variables
*(“we replace any observation below the 5th percentile with the 5th percentile, and any observation above the 95th percentile with the 95th percentile”*). But if we believe Taleb, in finance outliers drive the mean, and from the FF migration paper only 3% of small value stocks annually accounted for 60% of the historical SV annual returns. So ‘winsorizing’ may bias the results.

2. The logit model (0/1 dependent variable) seems to rely on a very small share of ‘failures’ in the overall data set (0.09% of total observations in the second paper as I understand). And the subsequent explanatory power seems relatively low.

- 1. Financial distress (probability of failure) is amplified in the smallest (micro) stocks. The portfolio sorts with highest probability of failure have size loads of 1.46, 1.55 and 1.98. These are micro-cap stocks (no surprise here).

2. The alphas in the 4-factor model are only consistently significant (and negative) for small/micro cap stocks (particularly for size loads of 1.46, 1.55 and 1.98.).

3. And the price-to-book on these highly distressed portfolios seems to go up. [also see figure 3: there seems to be a divergence between size and value loads towards the end of the chart]

4. So it may be that the main focus of the result is simply on the small/micro growth (higher price-to-book) portfolios (?). i.e. small growth stocks have delivered anomalously low returns (as we known).

Again, just my take.

Here are a few other papers on the subject:

- Default Risk in Equity Returns

Is Systematic Default Risk Priced in Equity Returns?

Is Default-Risk Negatively Related to Stock Returns?

Distress Risk and Stock Returns

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