DISTRESS RISK AND STOCK RETURNS

IN THE U.K. INDUSTRIALS INDUSTRY

Submitted By

Du D. Nguyen

Master of Science (MSc) in

Financial Analysis and Fund Management

University of Exeter

August 2012

DISTRESS RISK AND STOCK RETURNS

IN THE U.K. INDUSTRIALS INDUSTRY

Submitted by Du D. Nguyen

To the University of Exeter as a dissertation towards

the degree of Master of Science

By advanced study in Financial Analysis and Fund Management, August 2012

I certify that all material in this dissertation which is not my own work has been

identified and that no material is included for which a degree has previously been

conferred upon me.

Du Dinh Nguyen

24 August 2012

1

ACKNOWLEDGEMENTS

I would first like to sincerely thank my supervisor, Dr. Angela Christidis of Xfi

Centre for Finance and Investment at University of Exeter Business School. It has

been my humble experience to be working with Dr. Angela, who is always

thoughtful and supportive to her students. Her constant reviews, timely feedbacks,

and useful recommendations are extremely vital to the completion of this

dissertation. I have also learnt from Dr. Angela valuable research skills, which I

believe that they are of importance for my higher academic studies. I owe my deep

appreciations to Dr. Angela, because this dissertation could have not been

successful without her contributions.

I would also like to express my deep gratitude to my family and friends back in my

country. Although we are far in distance, still their words of supports are strong

motivation for me to keep up my works and achieve what I have today. Especially I

want to say many thanks and words of love to my parents for giving me a chance

to study here in the UK, the chance that helps me broaden my knowledge and

mind.

Finally, I would like to say thank you to all of my kind lecturers, dear classmates,

and friends here in Exeter, who have given me words of encouragement and

inspiration throughout the process. They have made my one-year studying here

happy and memorable.

2

ABSTRACT

In this dissertation, a dynamic logit model for bankruptcy prediction within the UK

Industrials sectors is developed based on Campbell et al (2008) proposal. By

investigating different variables, it is evident that market-driven predictors are more

dominant in forecasting failure events during the last decade. The study also

explores the relation between distress risk and stock returns within the industry. In

contrast to most of prior literature on the same topic (Dichev, 1998; Campbell et al,

2008; Agarwal and Taffler, 2008b), the results show that distresses stocks, which

have higher probabilities of bankruptcy, outperform non-distressed stocks. More

importantly

characteristic and the distress factor to derive profitable investment strategies.

Surprisingly to certain extent, its finding suggests that in order to earn higher

returns investors should pick stocks of small-sized firms with higher bankrupt

probabilities.

3

TABLE OF CONTENTS ACKNOWLEDGEMENTS ............................................................................................................................... 1

ABSTRACT ....................................................................................................................................................... 2

LIST OF FIGURES ........................................................................................................................................... 4

LIST OF TABLES ............................................................................................................................................. 4

I. INTRODUCTION ........................................................................................................................................... 5

1.1 Importance of Research ....................................................................................................................... 5

1.2 Aims and Objectives ............................................................................................................................. 7

II. LITERATURE REVIEW ............................................................................................................................... 9

2.1 Corporate Bankruptcy Prediction Models .......................................................................................... 9

2.2 Bankruptcy Prediction Models in the U.K......................................................................................... 11

2.3 The Relation between Financial Distress and Stock Returns ....................................................... 12

III. METHODOLOGY ...................................................................................................................................... 15

3.1 Corporate Bankruptcy Prediction: The Dynamic Logit Model ....................................................... 15

3.2 Model Accuracy and Adequacy Evaluation ..................................................................................... 16

................................................................... 18

IV. DATA .......................................................................................................................................................... 20

4.1 Sample Selection ................................................................................................................................. 20

4.2 Variable Calculation and Adjustments .............................................................................................. 21

4.3 Summary Statistics .............................................................................................................................. 23

V. RESULTS.................................................................................................................................................... 26

5.1 Logit Model of Bankruptcy .................................................................................................................. 26

5.2 Model Evaluation ................................................................................................................................. 30

5.3 Risk and Average Returns on Distressed Stocks ........................................................................... 34

5.4 Firm Characteristics and Strategic Implications .............................................................................. 37

VI. CONCLUSIONS ........................................................................................................................................ 41

6.1 Research Summary ............................................................................................................................. 41

6.2 Limitations and Recommendations ................................................................................................... 42

APPENDICES ................................................................................................................................................. 44

APPENDIX A: CONSTRUCTION OF PREDICTOR VARIABLES ...................................................... 44

APPENDIX B: FIGURES AND TABLES ................................................................................................. 45

REFERENCES................................................................................................................................................ 54