Paper: "Identifying Overvalued Equity" and the "O-Score"

Reading a paper called Identifying Overvalued Equity by Beneish and Nichols:

"Our model is a scoring system that combines firm characteristics into an overvaluation score (O-Score) ranging from zero to five. Firms receive one point for having a high likelihood of earnings overstatement (based on the Beneish (1999)’s PROBM measure), high sales growth, low operating cash flows to total assets, an acquisition in the last five years, and unusual amounts of equity issuance in the past two years. Thus, firms with glamour characteristics, poor current operating cash flow performance, a high likelihood of earnings overstatement, a history of merger activity, and recent but excessive issuances of stock fit our profile of overvalued equity. And, we show the overvaluation is substantial; firms with O-Scores equal to five lose about a quarter of their value."

Indexing idea: use Falkenstein's low volatility approach, and also prune any firms with high O-scores or high yield debt.

A Couple Papers About the Inefficient Market in Stock Lending

Previously,

1. "Market prices would be more accurate if it was easier (and cheaper) to borrow shares to sell short."
2. "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."

Two papers worth mentioning,

• "Securities Lending, Shorting, and Pricing": "The prospect of lending fees may push the initial price of a security above even the most optimistic buyer’s valuation of the security’s future dividends. A higher price can thus be obtained with some shorting than if shorting is disallowed."
• "A Dynamic Model for Hard-to-Borrow Stocks": "Consequences of our model for dynamics are elevated volatilities, sharp price spikes and occasional crashes followed by often dramatically lower hard-to- borrowness."

"Judges Feedback from FactSet Best Short Idea Contest"

From an email that Sum Zero sent out.

"Unless you’re looking at very small companies or you’re in a period of general market dislocation, you’re not dealing with neglect but instead taking a position on a controversial aspect of a business. Summarizing the available data from financials/presentations/CCs is 60-80% of the work; it basically puts you in an informed position as to what is controversial but it doesn’t provide an edge or advantage on the controversy. Said differently, getting to the point where you understand what is controversial is 60-80% of the work, and it is the easy part. You need to be analytical, but it doesn’t require discomfort or creativity."

Probably everyone in the business got this email, but kind of amusing to repost.

"A heuristic for solvency analysis of non-financials"

This idea by Hui does seem like a better model than Altman.

In a recession, the combination of high operating risk and excessive leverage combine to produce insolvency for non-financial company. A better way of forecasting solvency risk is to look for companies that show:

High operating risk: The top two deciles of standard deviation of EBIT or EBITDA margin over the last 5 or 10 years (pick your horizon)
High financial leverage: The top two deciles of financial leverage, by total debt to market equity or interest coverage. Normalized decile scores by sector.

I have found that this heuristic, or simple rule of thumb, serves as a better forecaster of solvency risk as it neutralizes many of the industry specific effects that Altman Z failed to address.

When Was the Last Good Market Corner? Volkswagen?

We've written about corners before: Joseph Leiter, the Hunt brothers, K-V Pharma's drug Makena, and Malaysian tin. Corners seldom happen now, perhaps because ownership disclosure requirements (e.g. 13D/G) have taken away the element of surprise.

It could happen again with Sears. Posters at CB&F have figured out that almost all the shares of Sears Holdings are owned by true believers with more than the remaining float sold short. (Between 85 and 95% "locked up", depending on how you define, and somewhere around 15% sold short.)

Baker Street Capital today released a very thorough report on Sears valuation, which also showed their calculations of short interest and float. They believe that 93.5% of shares are held by "committed shareholders," leaving 6.5% as the effective float, versus 14.8% sold short.

That would be 200% of the float sold short, about the same ratio (and absolute level) that was sold short at the start of the infamous Volkswagen squeeze. Which, by the way, was a thought that had occurred to people in advance. From a Risk.net article in 2008:

"Before the short squeeze occurred, various analysts had published research warning investors of the perils of trading VW stock. Adam Jonas, an analyst at Morgan Stanley in London, had cautioned clients of the dangers of playing 'billionaire's poker' in his research note on October 8, and suggested the size of short positions on VW far outweighed the true economic free float of the company. He added that Porsche needs VW to ensure its long-term survival, noting the company would not develop or manufacture a car in the future without significant resource sharing with VW or Audi (a car brand owned by VW). 'This 'need' for Porsche to control VW, combined with Porsche's long-term horizon, can create shorter-term share price anomalies that could take investors by surprise,' Jonas wrote."

Even though shorts are systematically smarter than many other types of investors, that academic research is more applicable in situations where institutional ownership is small and declining. In this case Sears is practically a private company.

Shorts can be wrong sometimes.



We've seen it from both sides now.

Chanos on Shortselling

Jim Chanos on Shortselling

This is from a Jim Chanos interview in the Graham & Doddsville Newsletter:

If you’re a short seller, that’s a cacophony of negative reinforcement. You’re basically told that you’re wrong in every way imaginable every day. It takes a certain type of individual to drown that noise and negative reinforcement out and to remind oneself that their work is accurate and what they’re hearing is not. Most people are in the “life’s too short to put up with this stuff” camp.

The other problem is that there’s an asymmetry on the return patterns of short ideas. Because markets tend to go up over time and you need discrete news to affect a short idea, you tend to have weeks and months and even years when you’re not making money in your ideas. Then when you do make money with a short idea, it happens all at once.Here once again, most people are just not hard wired to find that asymmetry comfortable but good short sellers are.

I'm always fascinated that most investors prefer being long equities (and also short volatility), and are very uncomfortable with shortselling.

That is also why I think it is funny that people are short CHK. Companies that are distressed or failing will enter a death spiral where they are able to obtain financing on less and less favorable terms. For example they will need to offer monthly amortization of a convertible loan, plus warrants, to get anyone to lend.

What we just saw CHK do is borrow unsecured to pay back a bank loan. That is actually moving in a favorable direction along the financing spectrum. As you would expect from a company with lots of valuable assets.

"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]

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.

FURTHER READING
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.

Nigerian Banks

Mark Mobius was quoted in Bloomberg last month saying that he liked Nigerian banks.

The money manager had earlier said at the same event that Africa has an “incredible” investment potential and that he has stakes in Nigerian banks.

“These banks are doing very well and are much better regulated than they were in the past,” Mobius said, without disclosing which lenders he holds.

Banks account for five of the eight stocks in the MSCI Nigeria (MXNI) Index.

The Nigerian banks had to be bailed outlast year to the tune of 2% of the country's GDP. What does he mean by "doing well"?

Taylor Conant writes in:

Its telling that most of these foreign etfs/indexes are composed of banks/finance companies. Banks and finance companies are supposed to follow savings and capital accumulation, not precede. These countries are broke, among many reasons, because they have no savings/capital accumulation.
How is this done? My guess is imf/world bank. Would love to know where all the loans from the local banks go, by the way. Want to bet to people connected to foreign companies/elites?

Yes. 

Top Ten Dying Industries

A company called IBISWorld has put together a report called "Dying Industries", which looks at the universe of close to a thousand industries to identify the 10 that are most hopelessly in decline.

These industries all experienced drastic revenue decreases over the past decade, and are expected to continue to decline, due to factors like damaging external competition, advancements in technology, and industry stagnation.

In descending order of 2010 revenue, the industries are:

1. Wired communications carriers
2. Mills
3. Newspaper publishing
4. Apparel manufacturing
5. DVD, game and video rents
6. Manufactured home dealers
7. Video postproduction services
8. Record stores
9. Photofinishing
10. Formal wear and costume rental

In most of these industries, the companies' valuations are already pricing in an eventual end to the industry. I think there may be shorting opportunities in paper, though, and in old-media companies generally.