Monday, June 20, 2011

Peculiar Market Inefficiency: Worthless Stocks That Refuse to Go to Zero

One of the most peculiar market inefficiencies is that the common stock of firms where the equity is clearly worthless will still persistently trade for long periods of time at positive values.

A classic example is General Motors. After the bankruptcy, the "old" General Motors changed its name to Motors Liquidation Company and sold its assets to a brand "new" GM, leaving the liabilities at the "old" GM. The "old" GM shares continued to trade, and the market could not quite grasp that the shares were worthless, even with lots of help from the company:

Management continues to remind investors of its strong belief that there will be no value for the common stockholders in the bankruptcy liquidation process, even under the most optimistic of scenarios. Stockholders of a company in chapter 11 generally receive value only if all claims of the company's secured and unsecured creditors are fully satisfied. In this case, management strongly believes all such claims will not be fully satisfied, leading to its conclusion that the common stock will have no value.
In October 2009, the shares still traded for about 60 cents each, which was a market capitalization of about $370 million. How can anyone believe in the semi-strong or strong efficient market hypothesis when this statement from a company fails to drive the share price to zero?

Evergreen Solar has warned investors that
"in order to significantly deleverage its balance sheet, any restructuring will involve very significant dilution to the Company’s existing stockholders, leaving them with at most a very small percentage of the Company’s outstanding common stock."
Putting aside the fact that this was an obvious outcome six months ago, shouldn't the stockholders now admit defeat? Especially now that the unsecured notes have traded at ten cents on the dollar, implying hundreds of millions of dollars in losses for bondholders? Yet the equity valuation is still in the eight figures - as much as the market value of the unsecured notes!

But, the efficient market adherents cry, maybe there is option value in these seemingly worthless shares, i.e. some chance, however remote, that they will receive a distribution? I don't think so. As Moyer writes in Distressed Debt Analysis, "in many of these situations, it is difficult to believe that a knowledgeable investor could sincerely believe there are scenarios which could occur, with sufficient probability to merit serious discussion, where the equity could have fundamental value." (p 50)

In fact, "the reality, based on the observation that many reorganizations have left stockholders with no recovery and yet the stock trades at positive values very late into, if not at the conclusion of, the reorganization, is likely that the buyers of the stock were simply wrong." (ibid)

So, why don't the vast majority of existing equity holders simply admit they made a mistake and sell the stock at whatever positive value can be obtained? A recent Businessweek article about a retail purchaser of shares in the defunct Blockbuster sheds some light on this situation.
Becker says he did not realize that the stock could end up worthless. He can't believe there was nothing on his screen to differentiate Blockbuster from other stocks he buys on E*Trade: "It's a different category than normal risk," he says. "If it's foreseeable shares would go to zero, I would think the powers that be would flash something—some kind of warning."
The investing thesis of many retail investors is: "The stock market is a playground. People make money by getting lucky. Someone else will do the work for me, for free."

All you need is one good counterexample to shoot a hole in the efficient market hypothesis, and this is a glaring one. I believe that this market inefficiency persists due to widespread investor ignorance, and the difficulty of shorting ultra small capitalization or very low priced stocks - which is that the stocks of worthless companies are before they go to zero.

All the same, it is good to know about this inefficiency. It is a great instant rebuttal of the EMH, plus there are situations where it is an investible inefficiency, for example our capital structure arbitrage trades.

Further reading. I am having trouble finding copies of these papers, but here are some citations on the topic:
Emshwiller 2002
Bonnier and Bruner 1982
Clark and Weisenstein 1983 "the behavior of common stock of bankrupt firms"
Morse and Shaw 1988
Shane 1994 ''Co-movements of Low Grade Debt and Equity Returns of Highly Levered Firms''


JamesDavid said...

E*Trade should make their retail investors watch this video after each transaction:

Taylor Conant said...

Does the price reflect the last price bid, or the current bid? If it's the last price bid, then the last price bid may be greater than zero and it may be a long time in the past but it was still greater than zero at that time.

If it's the current bid, then I am not sure why anyone would make a bid at all.

Does "zero" make sense as a price, though? Zero implies an exchange can occur at no cost to the buyer. I should think the more appropriate way to consider the price is "nil" or "empty", that is, there is no price whatsoever because there is no longer a market-- no one willing to bid and/or sell at any price whatsoever.

What we're trying to figure out is why someone would bid for a clearly worthless stock, not why someone wouldn't sell a clearly worthless stock, correct?

CP said...

Of course, if you can sell shares in a company whose bonds trade for less than a cent, more power to you.

The question is, who is buying, and why?

And, how can markets be "strong form" efficient if these inefficiencies can exist and persist?