Litigation Risk and Stock Return Anomaly

A dynamic logistic model shows that low-litigation-risk firms outperform high-litigation-risk firms, with annual alpha exceeding 8%. Evidence suggests that the excess return comes from investors underreacting to changes in firms’ litigation risk.

Overview

We create a proxy for security litigation risk using a dynamic logistic model and find that low-litigation-risk firms outperform high-litigation-risk firms. The out-of-sample long-short portfolio delivers an annual alpha of over 8%. This anomalous return is mainly driven by long positions in low-litigation-risk firms. The results are not affected by the realization of the lawsuits and are robust after controlling for other well-known anomaly factors. We provide evidence that the litigation-risk anomalous return is driven by investors’ under-reaction to the changes in firms’ litigation risk.