It seems obvious now that firms facing extreme financial difficulty should be avoided. EFF: This is a market efficiency question. If firms facing extreme financial difficulty are properly priced to take account of the risks they face, there is no reason to avoid them, unless you don't like the risks. KRF: Whenever you think about a proposition like this, you should ask yourself, "What do you know that the market doesn't?" Does the market know the firms are facing extreme difficulty? If so, your best bet is that the price is right. This does not mean that the price is always right, or even that the market always incorporates all publicly available information. Sure the price of a distressed firm may be too high, but it is equally likely it is too low. To decide how the market has erred in a specific case, you have to know more than the market or you need a better model than the market. Although most investors seem to think they have the expertise to beat the market, an enormous amount of empirical evidence says this is a very high bar.
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