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When troubles multiply

Troubled stocks tend to fall even further, which contradicts conventional economic theory.
April 5, 2018

One feature of 2018 so far is that several troubled companies have become even more troubled. Stocks such as Capita (CPI), Carpetright (CPR), AA (AA.), Mothercare (MTC) and Debenhams (DEB) have continued to fall, while Carillion has collapsed and Conviviality (CVR) is close to following it. These sad experiences confirm a historic pattern, for distressed stocks to do badly.

US evidence tells us this. Harvard University’s John Campbell has shown that companies on the verge of bankruptcy have on average delivered poor returns for shareholders. And Warwick Business School’s Richard Taffler and colleagues have shown that the shares in companies file for Chapter 11 bankruptcy fall by an average of 28 per cent in the 12 months after filing, which tells us that hopes that companies can be restructured and turned around are usually disappointed.

Much the same is true in the UK. One gauge of this is the performance of my negative momentum portfolio which comprises the 20 stocks with a market capitalisation of over £500m which have fallen most in the previous 12 months. Since I began it in 2011, this portfolio has lost 25 per cent while the FTSE 350 has risen more than 40 per cent.

All this is surprising from the point of view of conventional theory. Troubled shares are riskier than others and so should in principle offer higher returns. This is especially true because such firms carry more than average cyclical risk: they are more likely than others to do badly if the economy slows down. Because investors should fear recessions, such stocks should carry a large risk premium.

But they don’t. Why?

One reason lies in one of the earliest pieces of research in behavioural finance. Back in 1985 Hersh Shefrin and Meir Statman showed that investors tended to hold onto losing stocks in the hope they would somehow bounce back perhaps because selling at a loss means admitting to yourself that you were wrong, and we are reluctant to do this: they called this the disposition effect. This, however, means there’s a lack of selling pressure, which keeps share prices higher than they should be.

Something else does too – hope. Distressed shares offer us the small chance of massive rises if the company is rescued, refinanced or taken over. But investors pay too much for this small chance. One reason for this, says Professor Taffler, is that investors have lottery-type preferences. They prefer the small chance of big returns to the big chance of smaller ones. For example, a 1 per cent chance of a 100 per cent profit and a 50 per cent chance of a 2 per cent gain have the same expected value, but people pay more for the former. In this sense, troubled stocks do badly for the same reason that longshot bets in horse racing and football do.

Perhaps there’s something else. We forget that however low a share price is there is always a chance of a 100 per cent fall. In fact, though, death rates for companies are high, especially in the long run, even for larger companies – as, indeed, they should be in a healthy economy in which companies face strong competition.

We overlook this in part because of an availability heuristic; we are surrounded by surviving companies and so assume survival is normal while the countless companies that have collapsed soon become out of sight and out of mind.

Hendrik Bessembinder at Arizona State University has shown that most stocks underperform cash over their lifetimes and that the great long-run returns on the market generally is due to spectacular rises in a very few shares rather than to most companies doing well. In failing to appreciate this, we underestimate the chances that companies will collapse completely and so over price those stocks that are or might be close to death.

At this stage you might wonder: why don’t better-informed investors profit from these mistakes by short-selling troubled shares? If they did so, they’d drive their prices down quicker, to levels from which subsequent returns would on average be good.

The answer is that there are barriers to short-selling. Many institutional investors are forbidden to do so. And for others it is risky. Troubled stocks tend to be volatile. Even if they do badly on average they might well rise sharply on a few days. When they do so, short-sellers will have to put up cash as collateral against their short position. Such a demand – a so-called margin call – is, says the brilliant financial commentator Dan Davies, “one of the most frightening things in the financial world”.

With short-selling so dangerous the smart money – insofar as it exists – cannot drive prices down far enough. So troubled stocks tend to be over-priced on average.

That word “tend” is doing some work. A few distressed stocks do deliver great returns as they escape their woes. These, however, are exceptions to the general pattern. Investors would be wiser to assume that such shares will continue to struggle unless they have exceptionally strong reasons to believe otherwise.