Does Book-to-Market Equity Proxy for Distress Risk or Overreaction? by

This paper tests risk and overreaction explanations of the book-to-market equity (BE/ME) premium in returns by focusing on the joint relationship between distress and BE/ME. Within the most distressed firms, the difference in returns between high and low book-to-market securities is more than twice as large as that in non-distressed firms, and is largely driven by extremely low returns on firms with low BE/ME. These large return differentials cannot be explained by risk as captured by the Fama and French three-factor model, nor differences in economic fundamentals, such as profitability or the likelihood of delisting. In contrast, predictions of the overreaction hypothesis are borne out. Distressed firms exhibit the largest return reversals around earnings announcements, and the book-to-market return premium is largest in small firms with low analyst coverage.