Saturday, August 9, 2014

Paper: "Investing in Chapter 11 stocks: Trading, value, and performance"

Some key excerpts from the 2012 paper, "Investing in Chapter 11 stocks: Trading, value, and performance" by Zhaodong Zhong and Yuanzhi Li [pdf], shedding more light on our worthless-stock inefficiency:

"In our sample of 602 Chapter 11 filings from 19 98 to early 2006, most stocks are delisted from major exchanges and resume trading on Pink Sheets, an electronic quotation system operated by Pink OTC Markets Inc. In contrast to the traditional view that trading is scarce except for initial short-covering by previous short-sellers, we find that active trading activity exists throughout the Chapter 11 process. Despite the initial decline in prices and widening of bid–ask spreads, more than 50% of these stocks are traded on any given day, even for the firms that have been in Chapter 11 for as long as three years"
More proof that we are at not at the beginning of a secular bull market. You simply can't have this level of retail investor interest in the stock market - daytrading of stocks that are absolutely worthless - and not be at a social mood peak.
"Using the Black-Scholes model to calculate the option values of bankrupt stocks, we are able to explain about 25–35% of the cross-sectional variation of the observed market values of these stocks. More specifically, we find that the bankrupt equity value right after filing is positively related to asset value, asset volatility, risk-free rate, and expected duration, and is negatively related to liabilities."
In other words, retail investors are vastly overpaying for these out-of-the-money call options on business enterprises.
"It is surprising that investors lose so much money investing in Chapter 11 stocks, even given the fact that shareholders are residual claim holders in bankruptcy. Thus, the finding that Chapter 11 stocks underperform indicates the existence of market frictions. Our explanation for the negative returns is motivated by the Miller (1977) theory, which argues that, when investors have heterogeneous beliefs about the value of a risky asset in a market with restricted short-selling, prices will reflect the more optimistic valuation."
Market prices would be more accurate if it was easier (and cheaper) to borrow shares to sell short. My current thinking is that there should be a transparent stock lending market where stock lending transactions occur. For each tenor of stock loan, shares are bid and offered. Brokers and clearing firms should have a duty to maximize the value of securities in clients' margin accounts by offering them in the lending market and remitting all of the loan proceeds (minus transaction costs) to the clients.

The point of financial markets is to put accurate prices on assets, mainly ownership interests in businesses. Investing is basically a game where 100,000 people compete for prizes if they can find errors in market prices, e.g. prices that are inconsistent with each other. That's why the more abstract and focused on error-finding (arbitrage), the higher status and more consistently profitable that type of investing.

If you can generate positive returns through a market cycle with a low correlation to the equity indices, you've identified a consistent error that other investors are making in pricing ownership interests in businesses.


John said...

The average retail investor has very little ability to short individual stocks. At Schwab, for example, you can only short the retail momentum favorites - aapl, goog, cmg, sbux, etc. that Schwab holds in sufficient quantity in street name for its retail customers. The weak stocks you would want to short are always "HTB" and unavailable. That leaves the average retail investor with inverse index ETFs that are subject to the inevitable mathematics of loss due to volatility decay.

Anonymous said...

That's not true, John. You just need to pick up the phone and ask the securities and lending department to find you available shares. It'd be more efficient, as CP has highlighted, to automate the lending process online but they'll provide you with more info (in-house inventory, market rates to borrow from others, etc) over the phone.

John said...

I am aware that I can call Schwab and ask for a quote for borrowed shares, but I doubt that the average retail Schwab customer knows that is possible, (there is a tag with a number to call when you click on the HTB button on their StreetSmart Edge trading platform) but it is a complicated and friction generating process.

Anonymous said...

The bigger point is that it's hard for institutional investors to short shares of the junk that is owned by retail investors.

It's a win for the stock lending desks, which make monopoly profits off of an artificially small pool of lent shares, a lose for market efficiency, and a lose for the retail investors.

Think about it - a share loan has the same risk as any other margin loan. Interactive Brokers currently charges about 1% rate depending on the size of margin loan.

So why do stock loans with the same risk cost order of magnitude more? Why does it cost "99%" annualized to borrow shares where the short interest is only 15%? Why aren't the other 85% competing to earn that rate?

Because stock lending is a special club - for now - where part of the racket is an artificial scarcity of shares to loan and the other part is that these rents don't make their way back to the owners of the shares.