Sunday, August 7, 2011

Paper: "Who Trades the Stock of Bankrupt Firms?"

Some of my best trades this year have been shorts of companies where the equity is clearly worthless. That these shares persistently trade for long periods of time at positive values is one of the market's most peculiar inefficiencies. My theory was that the inefficiency persists due to widespread (retail) investor ignorance, and the difficulty of shorting ultra small capitalization or very low priced stocks.

I have finally found a paper that sheds some light on this market inefficiency, called "Who trades the stock of bankrupt firms?" [pdf] by Luis Coelho, Richard Taffler, and Kose John. They, too, notice that "retail investors are particularly drawn to the stock of bankrupt firms." Their research is based on the 351 public, non-finance, non-utility firms which filed for Chapter 11 (reorganization) between 1979 and 2005, and remained listed post-bankruptcy.

One question they studied is: who does really own the stock of bankrupt firms? They found that institutional investors sell down their equity position as the bankruptcy date approaches, and the dumping is amplified once the bankruptcy petition is actually filed. During the pendency of the bankruptcy, retail investors own an average of 90% of the firms' common stock. What little institutional ownership there is - an average of ten percent - must be held by funds that are asleep or indifferent as a matter of policy. For example, the homebuilding or solar energy exchange traded funds are going to own all of the public securities in those industries, no matter what. Given their dominance in this market, retail investors are the marginal investors in  in bankrupt firms, and therefore likely to be setting the stock prices.

The next question is, why do the retail investors buy this stuff, now that we know that they really are the ones doing the buying? The paper "Who Gambles in the Stock Market?" by Alok Kumar calls volatile stocks like bankrupt firms' "lottery-type stocks". The lottery stocks are characterized by idiosyncratic volatility, idiosyncratic skewness, and low stock prices. One of their theories is that the

"high idiosyncratic volatility is important in the sense that it may lead investors to amplify their perception about skewness. This would be especially true if they adopt an asymmetric weighting scheme and assign a larger weight to upside volatility and ignore or assign lower weight to downside volatility."
So, the retail investors are like bad poker players - the kind that learned the game by reading "Down to The River: Win by Never Folding". They don't mind losing it all as long as they have a shot at winning it big. They use the low priced shares of bankrupt firms "to satisfy their craving for gambling on the market".

The next question the paper answers is, what happens to the retail investors who buy the worthless stocks? The result of the study was "a strong, negative and statistically significant post-event drift that lasts for at least one full year after the Chapter 11 filing date with mean of -28%. Our findings seem to be inconsistent with market efficiency and appear to support the argument that markets are unable to digest bad news events on an unbiased and timely basis."

As is always the question with market inefficiencies: why doesn't someone arbitrage them away? Now, here is where the academics go astray: "we show that transaction costs severely hinder arbitrageurs’ ability to intervene in the peculiar market we study." This is the limits to arbitrage view. They claim that "due to restrictions that are placed on funds that would ordinarily be used by rational traders to arbitrage away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time." The academics think the problem is transaction costs: stock borrowing costs, trading commissions, and bid-ask spread.

There is a reason that these academics conclude that you cannot make money using a strategy that makes money. The best explanation for this is given in Panic: The Betrayal of Capitalism by Wall Street and Washington. Academic economists would only consider an arbitrage strategy valid if it applied across an entire market segment previously defined in some arbitrary, nonbiased way. But, as Andrew Redleaf and Richard Vigilante observe in Panic,
"This is exactly what adroit market practitioners do. We assume that potentially profitable anomalies appear and disappear as market conditions change. We assume that such anomolies are almost certain to be more powerful and profitable for some sets of securities than for others. We look into the nooks and crannies of the market for trends that we can exploit profitably with some securities for now."
As they conclude, "it is impossible to address the question of whether good judgment can produce excess returns through research methods that exclude the possibility of judgment."

The bankrupt stock inefficiency is part of a broader problem that the market has in correctly assimilating the implications of public domain bad news events. For example, there is the “distress anomaly” discussed in Campbell, Hilscher and Szilayi (2008), which shows that financially distressed stocks have delivered anomalously low returns, a result that clearly challenges standard models of rational asset pricing.

Aharony, J., Jones, C., and Swary, I., 1980, An analysis of risk and return characteristics of corporate bankruptcy using capital market data, Journal of Finance, 35, 1001-1016.
Barber, B. and Odean, T., 2002, Online investors: do the slow die first? Review of Financial Studies, 15, 455-487.
Campbell, J. , Hilscher, J., and Szilayi, J., 2008, In search of distress risk, Journal of Finance, 63, 2899-2939.
Chakravarty, S., 2001, Stealth-trading: Which trader's trades move stock prices?, Journal of Financial Economics,
Clark, T. and Weinstein, M., 1983, The behavior of the common stock of bankrupt firms, Journal of Finance, 38, 489-504.
D'Avolio, G. , 2002, The market for borrowing stock, Journal of Financial Economics, 66, 271-306.
Hubbard, J. and Stephenson, K., 1997a, A fool and his money: buying bankrupt stocks, Journal of Investing, 6, 56-65.
Kumar. A., 2009, Who gambles in the stock market?, Journal of Finance, 64, 1889-1933.
Russel, P. and Branch, B., 2001, Penny stocks of bankruptcy firms: Are they really a bargain?, Business Quest.


John said...

Great summary. Which stocks like this have been your best trades this year? Do you have any positions like this still on now?

CP said...

DM said...

1) I think the problem is that it is difficult to short the stocks once they are in bankruptcy.

2) Once all the intelligent people have quit selling, their is no one else left to sell. With no new shorts in the market, every new buy order raises the price.

CP said...

Sure, sometimes you can't short them. But sometimes you can.

Of course, most of the terminal phase shorts I do are not yet in bankruptcy, but I think the same pattern of retail trading applies.

Also, for stocks with options, you can always short synthetically.

Steve said...

A synthetic short of STP only fetches $1.20, vs a current quote of $1.53.

Steve said...

A synthetic short of STP only fetches $1.20 vs. a closing quote of $1.53!

CP said...

Hmm, I guess that's not surprising and not a bad deal, either.