Gold Miners and the Net Issuance Anomaly

From Crescat Capital's March 2021 letter:

Gold and silver companies continue to report exceptionally strong fundamentals. Free-cash-flow estimate for miners keeps improving despite the recent correction in precious metals. As we have seen throughout history, stocks tend to follow fundamental growth. We believe there is a major catch up in prices ahead of us. There used to be a time when all gold and silver miners would do was to invest in unproductive assets and dilute their capital structure to pay for it. Those days are over. For the first time in history, aggregate net equity issuance for the top 10 precious metals mining companies is now falling. In other words, these companies are buying back stock like we have never seen before. These are fundamentally cheap stocks that continue to benefit from this macro environment.

I'm a believer in the taking advantage of the net issuance anomaly (i.e. companies retiring debt and repurchasing shares outperform those raising capital).

Where does the anomaly show up today? Industries with companies that are returning capital to investors are banks, tobacco, energy, miners, pipelines. Industries that are raising capital are electric vehicles and many types of growth and tech - especially considering stock based compensation. (Although some tech is negative issuance, e.g. Apple.)

The net issuance anomaly is related to our Sector Rotation Value Strategy. One logical mechanism which would cause the net issuers to under-perform is that they are in the "over-investment" part of their industry cycle. They take the proceeds of their equity and debt issuances, and they expand capacity, driving each other's economic rents down.

Back in May 2014, I did a large cap value screen. It was based on highest trailing 10 year earnings yield and shrinking share count. The top 15 candidates were:

Apollo Education (APOL) - this went private, would have lost money
American Financial Group (AFG) - this has doubled
Coach, Inc (COH) - now TPR, this is flat
ProAssurance Corp (PRA) - got cut in half
The Gap (GPS) - down about 25%
Magellan Health (MGLN) - up 50%
Bed Bath (BBBY) - down 50%
Exxon (XOM) - down about 25%
Intel (INTC) - doubled
Microsoft (MSFT) - up 6x!
Murphy Oil (MUR) - down 2/3rds
Chevron (CVX) - flat
Apple (APPL) - up 7x!
Occidental (OXY) - down 2/3rds
Marathon (MRO) - down 2/rds

If you had owned them equal weight (6.7%), the Microsoft, Apple, and Intel positions would have returned your whole fund. However, the energy stocks killed the overall return. 

Maybe the key here was that the earnings yield didn't account for capital structure the way the "acquirer's multiple" (EV/EBIT or EBITDA) would.

The other thing is that with the acquirer's multiple, you don't just hold for 7 years but rotate every year to whatever is screening cheapest. So you wouldn't have held the oil (and also probably not the tech) this long. Now you would be in tobacco and mining companies!

Paper: "Corporate Pensions and Financial Distress"

NY times article:

"A paper by the academics Ying Duan, Edith S. Hotchkiss and Yawen Jiao, studied 729 troubled publicly traded companies over 20 years and found that the amounts of money that employees had in company stock remained relatively stable during periods of trouble, as did their new contributions. This is true even as the stock prices decline and the number of investors betting against the stock in the public markets through short sales increases."

From the paper abstract:

"We examine the role of corporate pension plans in determining how firms restructure in financial distress. Both defined benefit (DB) and defined contribution (DC) plans can have significant exposures to the company’s own stock, imposing significant losses on employees if the firm defaults and/or files for bankruptcy. We find that firms with DB plans typically have little exposure to the stock prior to default; the degree of underfunding increases significantly as firms near default, but is not related to restructuring types (bankruptcies versus out of court restructurings). In contrast, large exposures to company stock in DC plans often are not reduced prior to default. High levels of own-company stock ownership are positively related to default and bankruptcy probabilities. Our evidence suggests a link between employee-ownership related managerial entrenchment and default risk."

Very interesting. Their finding is (as we would expect) that the company employees are dumb money even when investing in the companies where they work. This is like all the people at Bear Stearns and Lehman that couldn't figure out their firms were going to fail.

An investing strategy is the systematized exploitation of an inefficiency

I've been saying that there are no evergreen investment strategies that will always work. As I said in that essay, having your investment operation in New York, having a Bloomberg terminal, and just being able to do a fundamental or technical screen of stocks were all alpha-delivering advantages once - long ago.

One of the good commenters on the Motley Fool boards gives a great example of this,

"These days I like not to have to travel into the city, and it is nice to be able to pull up a 10k or something at will. Decades ago I was comfortable in the knowledge that there we only two government offices (in the entire country!) that I could go to when I wanted to peruse a company’s recent SEC filings. At least for awhile, my office was conveniently just a couple of blocks away from one; less than a five minute walk.

That proximity was like having super-hero powers. Of course back then you could pay a third-party service to go make a copy of a particular filing you needed and mail it to you, but that wasn’t quite the same as just perusing filings on those little microfiche cards at will. I remember getting the phone message that someone wanted to talk to me about some company or other, I took a walk over to the SEC library and looked through the company’s recent filings, and when I returned the call a half hour later was asked incredulously and somewhat anxiously 'how do you know that!' There were some benefits to general inefficiency for those able to capitalize on it."

Making money is all about finding inefficiencies. Institutional investors aren't able to do anything with small companies, and they aren't able to go to cash, so it's amazing that individual investors and small funds don't take bigger advantage of these two inefficiencies.

An investing strategy is the systematized exploitation of an inefficiency. Keeping your money in munis 80% of the time and switching to stocks during a panic would be a strategy that would outperform but that institutional investors wouldn't be allowed to do.

Paper: "The Shorting Premium And Asset Pricing Anomalies"

Abstract:

"Short-rebate fees are a strong predictor of the cross-section of stock returns, both gross and net of fees. We document a large 'shorting premium': the cheap-minus-expensive-to-short (CME) portfolio of stocks has a monthly average gross return of 1.31%, a net-of-fees return of 0.78%, and a 1.44% four-factor alpha. We show that short fees interact strongly with the returns to eight of the largest and most well-known cross-sectional anomalies. The anomalies effectively disappear within the 80% of stocks that have low short fees, but are greatly amplified among those with high fees. We propose a joint explanation for these findings: the shorting premium is compensation for the concentrated short risk borne by the small fraction of investors who do most shorting. Because it is on the short side, it raises prices rather than lowers them. We proxy for this short risk using the CME portfolio return and demonstrate that a Fama-French CME factor model largely captures the anomaly returns among both high- and low-fee stocks."

Paper: "Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient Than You Thought"

Saw a new paper on CEF arbitrage, "Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient Than You Thought" by Dilip Patro, Louis R. Piccotti, and Yangru Wu.

"We find significant evidence of mean reversion in closed-end fund premiums. Previous studies substantially understate the magnitudes of arbitrage profits in the closed-end fund market. Capitalizing on the property of mean reversion, we devise a parametric model to estimate expected fund returns by incorporating the information content of a fund’s premium innovation history. Our strategy of buying the quintile of funds with the highest expected returns and selling the quintile of funds with the lowest expected returns yields an annualized arbitrage return of 18.2 percent and a Sharpe ratio of 1.918, which are substantially higher than the corresponding figures produced using the extant methods. The results are robust to a wide range of tests. They greatly deepen the closed-end fund discount puzzle and pose a challenge to the market efficiency in these products."

I'm sure they are right that there is mean reversion in CEF premiums. That's why we like the muni-CEFs right now, trading at in some cases record-wide discounts, all because of interest rate paranoia.

However, I don't see that this paper considered the cost to borrow the premium CEFs.That would be a difficult thing to study, as there is no dataset that I'm aware of on historical borrowing costs.

The stock lending market is too opaque, borrowing costs are too high, leading to not enough stock being shorted and prices being less accurate than they should be. However, short selling is "bad," so there is no political pressure to clean up the stock lending market.

Rule 10b-18 -- Purchases of Certain Equity Securities by the Issuer and Others

1. Section 240.10b-18 provides an issuer (and its affiliated purchasers) with a “safe harbor” from liability for manipulation under sections 9(a)(2) of the Act and § 240.10b-5 under the Act solely by reason of the manner, timing, price, and volume of their repurchases when they repurchase the issuer's common stock in the market in accordance with the section's manner, timing, price, and volume conditions. As a safe harbor, compliance with § 240.10b-18 is voluntary. To come within the safe harbor, however, an issuer's repurchases must satisfy (on a daily basis) each of the section's four conditions. Failure to meet any one of the four conditions will remove all of the issuer's repurchases from the safe harbor for that day.

(b) Conditions to be met. Rule 10b-18 purchases shall not be deemed to have violated the anti-manipulation provisions of sections 9(a)(2) or 10(b) of the Act (15 U.S.C. 78i(a)(2) or 78j(b)), or § 240.10b-5 under the Act, solely by reason of the time, price, or amount of the Rule 10b-18 purchases, or the number of brokers or dealers used in connection with such purchases, if the issuer or affiliated purchaser of the issuer effects the Rule 10b-18 purchases according to each of the following conditions:

(1) One broker or dealer. Rule 10b-18 purchases must be effected from or through only one broker or dealer on any single day; Provided, however, that:
(i) The “one broker or dealer” condition shall not apply to Rule 10b-18 purchases that are not solicited by or on behalf of the issuer or its affiliated purchaser(s);
(ii) Where Rule 10b-18 purchases are effected by or on behalf of more than one affiliated purchaser of the issuer (or the issuer and one or more of its affiliated purchasers) on a single day, the issuer and all affiliated purchasers must use the same broker or dealer; and
(iii) Where Rule 10b-18 purchases are effected on behalf of the issuer by a broker-dealer that is not an electronic communication network (ECN) or other alternative trading system (ATS), that broker-dealer can access ECN or other ATS liquidity in order to execute repurchases on behalf of the issuer (or any affiliated purchaser of the issuer) on that day.

(2) Time of purchases. Rule 10b-18 purchases must not be:
(i) The opening (regular way) purchase reported in the consolidated system;
(ii) Effected during the 10 minutes before the scheduled close of the primary trading session in the principal market for the security, and the 10 minutes before the scheduled close of the primary trading session in the market where the purchase is effected, for a security that has an ADTV value of $1 million or more and a public float value of $150 million or more; and
(iii) Effected during the 30 minutes before the scheduled close of the primary trading session in the principal market for the security, and the 30 minutes before the scheduled close of the primary trading session in the market where the purchase is effected, for all other securities;
(iv) However, for purposes of this section, Rule 10b-18 purchases may be effected following the close of the primary trading session until the termination of the period in which last sale prices are reported in the consolidated system so long as such purchases are effected at prices that do not exceed the lower of the closing price of the primary trading session in the principal market for the security and any lower bids or sale prices subsequently reported in the consolidated system, and all of this section's conditions are met. However, for purposes of this section, the issuer may use one broker or dealer to effect Rule 10b-18 purchases during this period that may be different from the broker or dealer that it used during the primary trading session. However, the issuer's Rule 10b-18 purchase may not be the opening transaction of the session following the close of the primary trading session.

(3) Price of purchases. Rule 10b-18 purchases must be effected at a purchase price that:
(i) Does not exceed the highest independent bid or the last independent transaction price, whichever is higher, quoted or reported in the consolidated system at the time the Rule 10b-18 purchase is effected;
(ii) For securities for which bids and transaction prices are not quoted or reported in the consolidated system, Rule 10b-18 purchases must be effected at a purchase price that does not exceed the highest independent bid or the last independent transaction price, whichever is higher, displayed and disseminated on any national securities exchange or on any inter-dealer quotation system (as defined in § 240.15c2-11) that displays at least two priced quotations for the security, at the time the Rule 10b-18 purchase is effected; and
(iii) For all other securities, Rule 10b-18 purchases must be effected at a price no higher than the highest independent bid obtained from three independent dealers.

(4) Volume of purchases. The total volume of Rule 10b-18 purchases effected by or for the issuer and any affiliated purchasers effected on any single day must not exceed 25 percent of the ADTV for that security; However, once each week, in lieu of purchasing under the 25 percent of ADTV limit for that day, the issuer or an affiliated purchaser of the issuer may effect one block purchase if:
(i) No other Rule 10b-18 purchases are effected that day, and
(ii) The block purchase is not included when calculating a security's four week ADTV under this section.

Paper: "Using Maximum Drawdowns to Capture Tail Risk"

Just saw a brand new paper, "Using Maximum Drawdowns to Capture Tail Risk" by Wesley Gray and Jack Vogel, which notes that "empirical asset pricing research focused on identifying anomalous returns often disregards tail-risk metrics".

They use maximum drawdown as their "easily measurable and intuitive" measure of tail risk for strategies exploiting anomalies.

What they find is that the best documented empirical anomalies (distress, net stock issuance, accruals, momentum) have horrible drawdowns - so big that no investor would tolerate them.

This set of results is actually perfect for the special situations practitioner. What the empirical research on anomalies is showing us is that there are some rich ponds to fish in. For example, the wonderful net stock anomaly where repurchasers outperform secondary issuers.

Yet, you can't just clumsily screen and apply a mechanical trading strategy - it pays to give the model output a reality check. The net current asset value strategy (not mentioned in this paper) was "broken" in 2010 and 2011 unless there was a human overseer that knew to look much, much closer at apparent free money on the ground in China.

Afterthought: all this really proves is that you couldn't run a fund exploiting just one of the anomalies, because of the drawdowns. But what are the correlations between strategies? How bad would the drawdowns be in a more realistic fund that was running each of the 10 anomalies as a strategy, for example?

No One Believes in Plans: The R&D Anomaly

From "Does the Stock Market Underreact to R&D Increases?" by Allan Eberhart, William Maxwell, and Akhtar Siddique,

"We examine a sample of 8,313 cases, between 1951 and 2001, where firms unexpectedly increase their research and development expenditures (R&D) by a significant amount. We find consistent evidence that our sample firms are undervalued following their R&D increases as manifested in the significantly positive long-term stock returns that our sample firms' shareholders experience. We also find consistent evidence that our sample firms have significantly positive long-term abnormal operating performance following their R&D increases. Our findings suggest that R&D increases are beneficial investments, and that the market is slow to recognize the extent of this benefit (consistent with investor underreaction)."

It could be investor underreaction, the phenomenon whereby investors are "anchored by salient past events". There is plenty of research showing that investors underreact to all sorts of news: good earnings, bad earnings, share repurchases, financial distress, dividend initiations, stock splits and reverse splits, and so forth.

But there's another hypothesis for an underreaction to research and development expenses, a theory we touched on last week: no one believes in plans. We have people like William Bernstein arguing that the long-run real rate of return on capital is one percent, if you're lucky. This is the indeterminate world idea that Peter Thiel talks about,

"In a determinate world, there are lots of things that people can do. There are thus many things to invest in. You get a high investment rate. In an indeterminate world, the investment rate is much lower. It’s not clear where people should put their money, so they don’t invest. [...] Indeterminacy has reoriented people’s ideas about investing. Whereas before investors actually had ideas, today they focus on managing risk. [...] In an indefinite world, investors will value secret plans at zero. But in a determinate world, robustness of the secret plan is one of the most important metrics. Any company with a good secret plan will always be undervalued in a world where nobody believes in secrets and nobody believes in plans. The ability to execute against long-term secret plan is thus incredibly powerful and important."

Underreaction to research and development is perfectly consistent with Thiel's idea. And public markets currently put a huge premium on predictable, non-divertable cash flows and more attractive (lower) multiples on cash flows that are seemingly uncertain.

Two New Investing Anomalies

First is "Institutional Investors’ Investment Durations and Stock Return Anomalies: Momentum, Reversal, Accruals, Share Issuance and R&D Increases" by Martijn Cremers and Ankur Pareek. They created a measure of institutional investor investment horizons based on quarterly institutional investor portfolio holdings, which is the 'average stock duration:' the weighted average of the duration the stock has been in the institutional portfolios. They find that

"the stock returns momentum anomaly only occurs for stocks that are generally held by short-term institutional investors. Similarly, the accruals and share issuance anomalies are much stronger for stocks with shorter investment horizons. Finally, short-term investors also under-react more to increases in R&D investment."

Second is "A Tale of Two Anomalies: The Implications of Investor Attention for Price and Earnings Momentum" by Kewei Hou, Lin Peng and Wei Xiong. They find that

"earnings momentum profit decreases with turnover [and] that the long-run returns of the earnings momentum portfolios for months 13-36 after portfolio formation show no sign of reversal. These results support our hypothesis that investors' underreaction to earnings news drives the earnings momentum effect and that the degree of underreaction weakens with investor attention."

The presence of short term investors is associated with stock mispricings. The accrual anomaly consists of investors focusing on headline earnings and failing to distinguish between accrual and cash flow components of earnings. Short term investors seem to be fixated on headline earnings, indicating that they are not reading financial statements very carefully. Or, alternatively, they buy stocks for trading and not for owning. Similarly, the benefits of research and development are long term and so short term investors ignore them.

Someone on Twitter was asking: why does every trade need a catalyst? Well, if the S&P 500 paid a 7 percent dividend yield, would anyone care about catalysts? What if companies with great moats like Google or railroads paid 7 percent dividends? Obviously no one would care about catalysts, they would just clip coupons.

I wonder whether the focus on catalysts is because the market is overpriced, in the sense that no one can live off of the coupons on a portfolio, and so staying ahead requires painstaking and original investment research looking for catalysts?

How does this relate to the short term investing anomalies? Well, by definition, a catalyst is a value-unlocking event that you hope happens soon. Focus on imminent catalytic events may be what causes short-term investing.