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{{nofootnotes, date=September 2009 A period of
financial distress Financial distress is a term in corporate finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. If financial distress cannot be relieved, it can lead to bankruptcy. Financial dist ...
occurs when the price of a company or an asset or an index of a set of assets in a market is declining with the danger of a sudden crash of value occurring, either because the company is experiencing increasing problems of cash flow or a deteriorating credit balance or because the price had become too high as a result of a speculative bubble that has now peaked.


Background

It is not known when this phrase was first used or by whom. However, it or phrases closely equivalent were almost certainly first used in connection with the theory of value investing as developed initially by
Benjamin Graham Benjamin Graham (; Given name, né Grossbaum; May 9, 1894 – September 21, 1976) was a British-born American financial analyst, economist, accountant, investor and professor. He is widely known as the "father of value investing", and wrote two ...
in his famous book
Security Analysis In finance, Security analysis is the evaluation and assessment of stocks or securities to determine their investment potential. It involves analyzing various factors, such as financial statements, industry trends, market conditions, and company ...
(Graham and Dodd, 1934). This theory advocated long-term investing in stocks or assets that are underpriced compared to their intrinsic value, that is they have suffered “distress sales” and the stock or asset of company is going through a “period of financial distress.” If such a period is temporary, and the company can be expected to return to an improved condition of normal solvency, then investing in such an asset can be expected to outperform the stock market in general in the longer run. In connection with this Graham developed the
Benjamin Graham formula The Benjamin Graham formula is a formula for the valuation of growth stocks. It was proposed by investor and professor of Columbia University, Benjamin Graham - often referred to as the "father of value investing". Published in his book, ''Th ...
, also known as “ net current asset value.” A similar analysis was done by
John Burr Williams John Burr Williams (November 27, 1900 – September 15, 1989) was an American economist, recognized as an important figure in the field of fundamental analysis, and for his analysis of stock prices as reflecting their " intrinsic value". He is ...
who developed his
discounted cash flow The discounted cash flow (DCF) analysis, in financial analysis, is a method used to value a security, project, company, or asset, that incorporates the time value of money. Discounted cash flow analysis is widely used in investment finance, re ...
theory (Williams, 1938). A prominent advocate of Graham and his approach has been
Warren Buffett Warren Edward Buffett ( ; born August 30, 1930) is an American investor and philanthropist who currently serves as the chairman and CEO of the conglomerate holding company Berkshire Hathaway. As a result of his investment success, Buffett is ...
, who has claimed that he is an “85% Graham investor” (Buffett, 2003). This approach has been criticized by advocates of
modern portfolio theory Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of Diversificatio ...
(MPT) and the closely related doctrine of the
efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis ...
(EMH) most closely associated with
Eugene Fama Eugene Francis "Gene" Fama (; born February 14, 1939) is an American economist, best known for his empirical work on portfolio theory, asset pricing, and the efficient-market hypothesis. He is currently Robert R. McCormick Distinguished Servic ...
(Fama, 1970). These theories argue that if a stock or asset is selling at what appears to be a “distress value” compared to some estimate of its true value based on its current income flows, then the market has information about the expected future of the company or asset that is not reflected in its current income flow. In this regard, investors such as Buffett who have successfully used the Graham approach should expect to spend extra resources to have better information about the companies or assets they purchase compared to most agents in the market. A study that shows that the Graham approach may well do better than various other alternatives (such as the “three-factor theory” that Fama and French, 1996, have argued performs better than the EMH), is Xiao and Arnold (2008).


Use in forecasting corporate bankruptcies

Another use of this phrase has been in connection with efforts to predict corporate bankruptcies that may come out of such a period of financial distress. One who developed an approach to making such predictions has been
Edward Altman Edward I. Altman (born June 5, 1941) is a Professor of Finance, Emeritus, at New York University's Stern School of Business. He is best known for the development of the Altman Z-score for predicting bankruptcy which he published in 1968. Profe ...
, who developed the
z-score In statistics, the standard score or ''z''-score is the number of standard deviations by which the value of a raw score (i.e., an observed value or data point) is above or below the mean value of what is being observed or measured. Raw scores ...
financial analysis tool (Altman, 1968). Further study of this and related tools has been done by Altman and Hotchkiss (2005). This idea can be related to the earlier issue in that presumably why the Graham approach might not do as well as such alternatives as MPT or EMH is that it does not satisfactorily account for the risk of such bankruptcies. Again, it is clear that to outperform such models a Graham-style investor will have to have sufficiently good information about such possibilities to know whether or not such a threat can be discounted.


Use in analysis of speculative bubbles and crashes

Drawing on these uses from
corporate finance Corporate finance is an area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analy ...
,
Hyman Minsky Hyman Philip Minsky (September 23, 1919 – October 24, 1996) was an American economist and economy professor at Washington University in St. Louis. A distinguished scholar at the Levy Economics Institute of Bard College, his research was inten ...
applied the phrase to analyzing speculative bubbles and crashes (Minsky, 1972), using it to characterize a period in a speculative bubble that follows a peak in price, in which the price gradually declines, and which is then followed by a crash in which the price falls precipitously. This analysis was adopted by
Charles P. Kindleberger Charles Poor Kindleberger (October 12, 1910 – July 7, 2003) was an American economic historian and author of over 30 books. His 1978 book ''Manias, Panics, and Crashes'', about speculative stock market bubbles, was reprinted in 2000 after the ...
, who in Appendix B of the 4th edition of his book, ''Manias, Panics, and Crashes'' (2000) identified 37 out of 47 historical bubbles as exhibiting such a pattern, including most of the more famous ones. Although the phrase was not used, participants in periods of financial distress in early bubbles used a variety of colorful terms and phrases for them, such as "apprehension" or "an ugly drop in the market" during the South Sea bubble in Britain in 1720 (Carswell, 1960, p. 139). Arguably the recent global bubble in financial derivatives exhibited this pattern, with a peak in August 2007, followed by a crash in September 2008. The first to develop a mathematical model of this period of financial distress was J. Barkley Rosser, Jr. (Chapter 5, 1991), drawing on catastrophe theory, while a more detailed such model using
agent-based modeling An agent-based model (ABM) is a computational model for simulating the actions and interactions of autonomous agents (both individual or collective entities such as organizations or groups) in order to understand the behavior of a system and ...
and relying on the wealth constraint idea due to Minsky has been done by Gallegati, Palestrini, and Rosser (2011.)


References

*
Benjamin Graham Benjamin Graham (; Given name, né Grossbaum; May 9, 1894 – September 21, 1976) was a British-born American financial analyst, economist, accountant, investor and professor. He is widely known as the "father of value investing", and wrote two ...
and
David Dodd David LeFevre Dodd (August 23, 1895 – September 18, 1988) was an American educator, financial analyst, author, economist, and investor. In his student years, Dodd was a ''protégé'' and colleague of Benjamin Graham at Columbia Business School ...
. 1934. Security Analysis: Principles and Technique. New York: McGraw-Hill (sixth edition, 2008). *
John Burr Williams John Burr Williams (November 27, 1900 – September 15, 1989) was an American economist, recognized as an important figure in the field of fundamental analysis, and for his analysis of stock prices as reflecting their " intrinsic value". He is ...
. 1938. The Theory of Investment Value. Cambridge: Harvard University Press. *Warren Buffett. 2003. “Preface” to Benjamin Graham and
Jason Zweig Jason Zweig is an American financial journalist. He has been a columnist for ''The Wall Street Journal'' since 2008. Biography Zweig received his B.A. from Columbia University in 1982. He also studied Middle Eastern history and culture at the ...
. 2003. The Intelligent Investor, revised version of 4th edition. New York: Harper-Collins. *
Eugene Fama Eugene Francis "Gene" Fama (; born February 14, 1939) is an American economist, best known for his empirical work on portfolio theory, asset pricing, and the efficient-market hypothesis. He is currently Robert R. McCormick Distinguished Servic ...
. 1970. “Efficient capital markets: a review of theory and empirical work.” Journal of Finance, 28(2), 383-417. *Eugene Fama and
Kenneth French Kenneth Ronald "Ken" French (born March 10, 1954) is the Roth Family Distinguished Professor of Finance at the Tuck School of Business, Dartmouth College. He has previously been a faculty member at MIT, the Yale School of Management, and the Un ...
. 1996. “Multifactor explanations of asset pricing anomalies.” Journal of Finance, 51(1), 55-84. *Ying Xiao and Glen C. Arnold. 2008. “Testing Benjamin Graham’s net current value strategy in London.” The Journal of Investing, Winter 17(4). * Edward I. Altman. 1968. “Financial ratios, discriminant analysis and the analysis of corporate bankruptcy.” Journal of Finance, September, pp. 189-209. *Edward I. Altman and Edith Hotchkiss. 2005. Corporate financial distress and bankruptcy: predict and avoid bankruptcy, analyze and invest in distressed debt, 3rd edition. New York: Wiley & Sons. *
Hyman P. Minsky Hyman Philip Minsky (September 23, 1919 – October 24, 1996) was an American economist and economy professor at Washington University in St. Louis. A distinguished scholar at the Levy Economics Institute of Bard College, his research was intent ...
. 1972. "Financial instability revisited: the economics of disaster." Reappraisal of the Federal Reserve Discount Mechanism. Washington: Board of Governors of the Federal Reserve System, pp. 95-136. *
Charles P. Kindleberger Charles Poor Kindleberger (October 12, 1910 – July 7, 2003) was an American economic historian and author of over 30 books. His 1978 book ''Manias, Panics, and Crashes'', about speculative stock market bubbles, was reprinted in 2000 after the ...
. 2000. Manias, Panics, and Crashes: A History of Financial Crisis, 4th edition. New York: John Wiley & Sons (first edition, 1978, New York: Basic Books). *John Carswell. 1960. The South Sea Bubble. London: Cresset Press. * J. Barkley Rosser, Jr. 1991. From Catastrophe to Chaos: A General Theory of Economic Discontinuities. Boston/Dordrecht: Kluwer Academic Publishers. *
Mauro Gallegati Mauro Gallegati (born 8 March 1958) is an Italian New-Keynesian economist, scholar of agent-based economics, and professor at Marche Polytechnic University in Ancona, Italy. Biography After having earned his PhD in economics in 1989 at Marche ...
, Antonio Palestrini, and J. Barkley Rosser, Jr. 2009. "The period of financial distress in speculative markets: interacting heterogeneous agents and financial conditions," Macroeconomic Dynamics, 2011, vol. 15, no. 1, pp. 60-79. Bankruptcy Fundamental analysis Valuation (finance)