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.

Great Point From Prechter About Indexing/Diversification

"In a tribute to the tailwind of a bull market, Fama’s emergence from disrepute was enough to earn him a share of this year’s prize. But the next major wave down in stocks should prove more devastating to the idea of rational markets. When stocks move below the 2009 lows, many mathematical models will fail, just as they did in 2008. Various wonders of modern financial engineering, such as Sharpe’s Financial Engines, will not be far behind. New studies attesting to the potential for extreme market moves and long periods of undervaluation will warn about the hazards of leverage and diversification. Indexation will be branded a bad strategy because it locks people into falling markets, induces them to ignore differences among individual companies and creates an intellectual detachment between investors and their holdings. Market action will reinforce ideas of non-rational markets."

Worthless Stock Inefficiency: Eastman Kodak ($EKDKQ)

Today, Eastman Kodak emerged from bankruptcy. The confirmed plan wiped out the existing common stock, which was cancelled.

"On September 3, 2013, the Plan became effective pursuant to its terms and the Debtors emerged from their chapter 11 cases.

Upon the effectiveness of the Plan, all previously issued and outstanding shares of the Company's common stock were cancelled as were all other previously issued and outstanding Equity Interests."

What is amazing is that everyone knew that the plan had been confirmed and that the shares were going to be cancelled. Yes, the company market cap was $35 million earlier in the month and was $16 million earlier today. Even in the final seconds before the stock was extinguished, the market cap was $8 million.

Note that there was no options related reason to be buying the shares. Here is how the OCC adjusted the Kodak options contracts:

Effective September 4, 2013, existing EKDKQ options will be adjusted to no longer call for the delivery of Eastman Kodak Company Common Shares upon exercise.

In settlement of EKDKQ exercise/assignment activity, an EKDKQ put exerciser (or call assignee) will receive a cash payment of the full aggregate strike price amount on the exercise settlement date. An EKDKQ put assignee (or call exerciser) will pay this amount on the exercise settlement date. Settlement will take place through OCC’s cash settlement system on the third business day after exercise.

Full strike!

It is analogous to Suntech, which is defaulted and has announced that shareholders will be "severely diluted" if they can even make a restructuring plan work. 

Something similar happened with GMX Resources as well. When the company borrowed money at 15% with 20% of the equity thrown in to the lender, the stock doubled.

Paper: "Low-Risk Investing Without Industry Bets"

New paper:

"The strategy of buying safe low-beta stocks while shorting (or underweighting) riskier high-beta stocks has been shown to deliver significant risk-adjusted returns. However, it has been suggested that such 'low-risk investing' delivers high returns primarily due to its industry bet, favoring a slowly changing set of stodgy, stable industries and disliking their opposites. We refute this. We show that a betting against beta (BAB) strategy has delivered positive returns both as an industry-neutral bet within each industry and as a pure bet across industries. In fact, the industry-neutral BAB strategy has performed stronger than the BAB strategy that only bets across industries and it has delivered positive returns in each of 49 U.S. industries and in 61 of 70 global industries. Our findings are consistent with the leverage aversion theory for why low beta investing is effective."

GMO on "Evidence in Favor of Oligopolies and Against Modigliani-Miller"

Latest from GMO [pdf]:

"Modigliani-Miller’s theory on capital structure irrelevance provides a model for explaining corporate profitability. As the theory would have it, if an equity holder wants more profits, he would simply lever up. In their model, higher profits are achieved through higher risk (in the form of leverage) of the entity. In fact, in the real world the opposite is true. We find striking evidence that Messrs. Modigliani and Miller have the sign wrong. Empirically, companies with persistently high profitability have lower leverage, and companies with persistently low profitability have higher leverage (Exhibit 1)."

Paper: "What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?"

Quantitative Trading posted a link to a paper about using option volatility smirk as a way to pick longs and shorts called "What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?" [pdf]. Volatility "smirk" is the difference between the implied volatilities of out-of-the money (OTM) put and at-the-money (ATM) call options.

This is in the same vein as the paper we posted last week, "The Information Content of Option Demand," which showed a relationship between stock returns and option demand imbalances caused by investors with information on the underlying.

The smirk paper finds that by ranking according to volatility smirk, forming a long portfolio consisting of stocks in the bottom quintile and a short portfolio with stocks in the top quintile, and updating weekly, there is an annualized excess return of 9.2%. The theory is that informed traders are buying OTM puts when they anticipate bad news, thereby driving up the implied volatilities of the puts relative to the ATM calls.

What if I told you that the implied vol of a Suntech Power March OTM put is 263 and an ATM call is 145, for a skew of 118? By comparison, the skew for Apple is about 6.

Also, related to the other option demand paper, there is an open interest of ~100k Suntech put contracts for March versus only about 20k call contracts - five times as many.

New Paper: "Short interest, returns, and fundamentals"

A new paper (February 2013), "Short interest, returns, and fundamentals", by Ferhat Akbas, Ekkehart Boehmer, Bilal Erturk, and Sorin Sorescu. Findings:

• "If short sellers are detectives who uncover future bad news, bad news should follow periods of heavy shorting. [...] In a given month, the most heavily shorted stocks have the most negative public news the following month. At the other extreme, the least shorted stocks have the most positive public news the following month. The relation between short interest and future news is almost monotonically decreasing..."
• "[R]esidual institutional ownership ... measures the deviation of a firm’s institutional ownership from the average institutional ownership within its size decile, in any given quarter. [T]his result [short interest predicts negative news] is stronger when residual institutional ownership is low.
• We show that short sellers correctly anticipate negative earnings surprises, bad public news, and downgrades in analyst earnings forecasts several months ahead. Their ability to predict future fundamental news events appears to be the dominant driver of their ability to predict future returns. Shorts seem to be particularly well informed about stocks with low levels of institutional ownership, which are presumably harder to short.

I think you could measure the smartness of investor groups and look at whether they are long or short a particular equity. Smartest groups: insiders, shortsellers, competent asset managers for whom the position is a big position. Dumb groups: retail, index funds, most long-only funds.

We know 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.

Another variable would be the rate of change of the constituent groups' holdings. Shortsellers adding, insiders doing nothing, retail buying? That's a classic implosion pattern.

Something else you never hear about: whether insiders own their companies' debt securities. Do the GMXR execs own the 2015 paper yielding 40%?

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.

Market Anomaly

In my previous post, I mentioned the institutional owners of Suntech who own stock in a company with bonds yielding 500-1000% to maturity. What is wrong with them? Why on earth wouldn't you trade up in the capital structure?

Similarly, GMX Resources is apparently unable to borrow unsecured, as evidenced by its recent secured borrowing and the fact that its unsecured debt yields 40 percent. How can you justify owning the equity?

I just saw an important paper on our worthless stock inefficiency concept: Dead Stocks Walking: Investor Irrationality in Worthless Stocks,

"This study documents clear evidence of investor irrationality using a sample of bankrupt firm stocks that were canceled without any payoff under the confirmed reorganization plan. Although the intrinsic value of these stocks is zero after the plan confirmation, some of them have sizable dollar trading volume. Prices are higher for more heavily traded or popular stocks, which are more likely to attract uninformed investors. We also document irrational price responses of the worthless stocks to news events. Short-covering cannot account for the price and trading volume observed for worthless stocks."

STP and GMXR aren't worthless yet, but the bond prices imply that they are well on their way to being there.

Worthless Stock Inefficiency in Action

One of my themes is something I call the "worthless stock inefficiency". I've done seven posts about this: [1,2,3,4,5,6, 7]. I've discovered that the buyers of these worthless stocks organize and recruit themselves - to pump the stocks up - on Twitter. For example:

Augusta Friends (@augustafriends)
5/29/12 9:38 AM
$GMXR - My target $1.29 after it investorshub.advfn.com/boards/read_ms…

Augusta Friends (@augustafriends)
5/29/12 7:57 AM
$AONE new HOD coming!!! investorshub.advfn.com/boards/read_ms…

If you follow the Twitter streams for the stocks that have cheap bonds, you can see a lot of this activity: AONE, GMXR, and KV-A, for example.

Remember this important conclusion from the paper about statistical properties of bankrupt equities:

during the 100 days preceding bankruptcy, a stock's volatility and volume both tend to increase more than usual, and so the two become more strongly correlated than normal. So even without knowing the underlying causes of the increased volatility and volume, the strong correlation provides a statistical indication of approaching bankruptcy.

It seems as though no one else has caught on to the worthless stock inefficiency.

Paper: "Low Risk Stocks Outperform within All Observable Markets of the World"

As Whitebox Selected Research writes, "The Basic Pillar of Modern Finance has Fallen".

A study by Robet A. Haugen and Nardin L. Baker claims that "Low Risk Stocks Outperform within All Observable Markets of the World". From the paper:

"The fact that low risk stocks have higher expected returns is a remarkable anomaly in the field of finance. It is remarkable because it is persistent – existing now and as far back in time as we can see. It is also remarkable because it is comprehensive. We shall show here that it extends to all equity markets in the world. And finally, it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward."

In other words, the Capital Asset Pricing Model and the EMH, which are still in textbooks and taught to students, are wrong. A great deal of money is managed with the assumption that risk=reward, and managers buy volatile securities that are now shown to have lower expected returns. Why would this inefficiency exist? The authors' hypothesis is that

"agency issues create demand by professional investors and their clients for highly volatile stocks. This demand overvalues the prices of volatile stocks and suppresses their future expected returns."

In other words, if your compensation mechanism is an option, then volatility in the asset portfolio increases the value of your option. And enough managers do this that the volatile assets are overpriced, and underperform. However, the authors also note that

"significant amounts of assets are now being shifted from inefficient capitalization-weighted portfolios dominated by over-valued growth stocks into more efficient investments"

This is an astonishingly important paper (5/5) and yet it has fewer than 1,000 downloads!

"Statistical analysis of bankrupting and non-bankrupting stocks."

This statistical analysis of bankrupting stocks is consistent with the research we've been doing on the worthless stock inefficiency:

The new statistical physics analysis uncovered several ways in which the behavior of stocks approaching bankruptcy differs from that of non-bankrupting stocks. One of the biggest differences is in the distribution of returns: pre-bankrupt stocks are more likely to have larger daily returns (both positive and negative) than stocks that don't become bankrupt. In other words, pre-bankrupt stocks have larger day-to-day price fluctuations. As would be expected, the difference is bigger for negative returns than positive returns, indicating the falling stock price preceding a bankruptcy. The closer the day of bankruptcy approaches, the greater the possibility for these dramatic price changes.

A second major difference between pre-bankrupt stocks and others is that the former experience a stronger correlation between volatility and volume. Previous research has shown that volatility and volume exhibit a positive correlation, meaning that large changes in stock price are often accompanied by large changes in trading volume. But during the 100 days preceding bankruptcy, a stock's volatility and volume both tend to increase more than usual, and so the two become more strongly correlated than normal. So even without knowing the underlying causes of the increased volatility and volume, the strong correlation provides a statistical indication of approaching bankruptcy.

We've done six posts so far on the worthless stock inefficiency: [1,2,3,4,5,6]

A Worthless Stock Buyer, Observed in the Wild!

This is from an article on "thestreet.com" called "5 Stocks Under $10 Set to Soar". Before we start, raise your hand if you think that the stocks are expected to soar for fundamental reasons. If you said yes, go back to square one.

"Traders savvy enough to follow the low-priced names and trade them with discipline and sound risk management are banking ridiculous coin on a regular basis. [...] I definitely love to trade stocks that are priced below $10. I like to view them as a trading vehicle with lots of volatility and lots of upside when the trade is timed right."

Note that his emphasis was on "trade" - and on not getting caught holding the bag. He mentions three solar stocks (!), including Energy Conversion Devices.

Anyway, his comment about volatility is funny, because it is precisely the hypothesized reason for the worthless stock inefficiency. As Kumar (who calls them "lottery-type stocks") wrote,

"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 "set to soar" article is another data point in support of our worthless stock theory.

Limits to Arbitrgage: The Dual Chesapeake Preferreds

Here is a market inefficiency for you. Chesapeake Energy has two different publicly traded preferred stocks, both with a face value of $100, and both cumulative and convertible.

• The 4.5% coupon, which is listed on the NYSE, has a conversion price of $43.91.
• The 5% coupon trades on the pink sheets and has a conversion price of $38.81.

The second preferred has a higher coupon and a lower conversion price. You'd expect it to trade at a higher price than the first one, right?

Wrong. The lower-yielding, NYSE-listed preferred trades at roughly $90, which is a yield of 5 percent and a conversion parity of $39.52. The second preferred trades at around $80, which is a yield of 6.25% and a much lower conversion parity of $31.

There should be a total layup arbitrage here: buying the second one at a yield of 625 and shorting the first one at a yield of 500, and pocketing a 125bp yield spread plus a huge conversion premium. Except I cannot locate the NYSE listed one to short: a limit to arbitrage.

By definition, anyone who owns the first one is totally asleep at the switch. They could buy an equivalent security that yields more and has a much more attractive conversion feature.

[Note: Assuming the NYSE-listed pref is trading at the correct price and yield, the pink sheet pref should be trading at par, not 80!]

Another Paper on Worthless Stocks: "Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns"

The paper is called "Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns", and is in the same vein as our previous research [1,2,3,4] on the worthless stock inefficiency.

This paper looked at the role of extreme positive returns in the cross-sectional pricing of stocks. They sorted stocks by their maximum daily return during the previous month and examined the monthly returns on the resulting portfolios (over the period from 1962 to 2005).

The relationship between maximum daily return and subsequent returns is negative, consistent with the other research we have seen about "lottery ticket" (worthless) stocks. These authors also believe that (retail) investors overpay for stocks that exhibit extreme positive returns, and that these stocks consequently exhibit lower returns in the future.

Their results were robust to sorting stocks not only on the single maximum daily return during the month, but also the average of the two, three, four or five highest daily returns within the month. That makes sense: what counts is whether a worthless stock experiences a squeeze. Once the squeeze dissipates, the subsequent returns are negative.

Their cognitive bias explanation for this inefficiency is that "errors in the probability weighting of investors cause them to over-value stocks that have a small probability of a large positive return."

Paper: "How Well Do Financial Markets Separate News from Noise? Evidence from an Internet Blooper"

"How efficiently do financial markets process news of unexpected events? [W]e examine an unusual episode involving a false news report that provides a unique look into this question. We find that even when noise can be clearly identified, markets may take as long as a week to fully process the 'signal,' or relevant information, component of news."

Another Obvious Market Inefficiency: Stock Returns by Debt Rating

From Falkenblog.

More Notes About the Worthless Stock Inefficency

Some more notes about the worthless stock inefficiency:

• The SEC’s 2003 annual report [pdf] talks about their campaign against worthless stocks: “During 2003, we received numerous complaints from investors who purchased stock in bankrupt companies under the mistaken belief that the stock price would rise when the company emerged from bankruptcy. In each case, however, the company had announced in its plan of reorganization its intention to cancel its existing common stock and to issue new stock.”
• In a paper called Who Gambles in the Stock Market [pdf] by Kumar (2009) shows that "poor, young, less educated single men who live in urban areas, undertake non-professional jobs, and belong to specific minority groups (African-American and Hispanic) tend to invest more in these lottery-type stocks."
• In an article called Corporate Bankruptcy and Insider Trading [pdf] Seyhun and Bradley (1997) say that they find "significant sales by the insiders of firms filing bankruptcy petitions prior to the filing date."