Trading Strategy of Firms in Financial Distress

This paper tests two hypothesis 1) that firms entering financial distress incur costs that depress the stock price 2) firms entering financial distress are over sold, and the year after they enter financial distress the price bounces back. The paper tests a simple trading strategy of buying the distressed firm and selling the largest firm in the industry. The strategy yields an average return of 10.16%. The returns are enhanced by sorting firms by price to book and selecting firms from the highest quartile, yielding an average return of 34.75