Saturday, January 21, 2012

Betting on Disaster For Fun and Profit

I've long been attracted to the idea of investing in companies in the midst of disaster. Emotional investors always overreact, and there's no more emotional moment than corporate disaster. So unless a given disaster is fatal (and it's not easy to kill a company to bankruptcy in one fell swoop), the stock will always spring back, at least some. The market will, once heads cool, correct the overreaction. And this strikes me as a terrific opportunity for pre-cooled heads.

Have a look at the one month view of Carnival Cruise (CCL), which suffered an, ahem, setback last week with the whole cowardly incompetent captain $90M boat sinking thing.

The stock sunk (sorry) on Tuesday, the next trading day after the news hit, by about 15%. From there, it's been a steady rise. If one had invested Tuesday morning, in the $29s, by Friday afternoon, when it was back up to the $31s, you'd have made nearly 7% profit. And I bet in a couple weeks, it will go to $32, for 10% profit. A great return for a quick hit investment!

Two things to note:

1. This wasn't a situation where more harmful news was likely to unfurl. If we learned that the captain had been drunk, or if additional deaths were announced, that wouldn't have had much additional effect on the stock price. This was a one-hit disaster, and Carnival took the hit all at once. In other words, the low of the trading day following the disaster was likely the true low.

2. None of this could be imagined to permanently injure (much less destroy) the company in the long term. Short to mid-term, sure, some people will be (justifiably!) scared to take cruises. But it's not an existential crisis. It was clear to reasonable observers that Carnival would eventually recover. So buying in at the bottom wasn't a particularly risky thing to do.

Also, have a look at the stock of Martha Stewart Omnimedia (MSO) in March of 2004, which includes the March 5 verdict of Ms. Stewart's insider trading case. It plunged from mid-teens to as low as $8.55 (though only for a moment; really, mid-$9s were the effective bottom). By March 24, three weeks after the bomb hit, the stock had scratched its way back to $11 for a 16% gain from $9.50.

If you watch for this sort of thing, you'll notice that the market always overreacts, and (barring unforeseen and unrelated circumstance), there's usually a short term snap back...if, and only if, the disaster is both one-pointed and non-existential.

Two caveats:

1. It's easier to spot a bottom (the point to buy at) when reviewing historical charts than it is to do so as events unfold in real time. But post-disaster lows tend to appear sometime during the following trading day. On the other hand, there don't seem to be many contrarians with my perspective out there, so there's usually plenty of time to buy in before the overreaction's corrected.

2. Short-term trades such as this are steeply taxed, which eat away plenty of the profit. You might hold the investment for a year so you enjoy long term capital gains rates, but then you're playing a whole other game, and none of the above pertains. I'm talking about short-term recovery, which has to do with market activity, not long-term recovery, which has to do with corporate competence...and which is, obviously, far less predictable.

PS - you can play a bigger, broader, longer version of the same game by investing in index mutual funds (which spread your investment out to most or all stocks) whenever the market falls super low. The same irrational overreaction (both upward and downward) usually takes place, creating opportunity for the cool-headed. And this involves less risk (since you're not betting on one single company) and lower taxation (since you'd be holding stocks through longer swing cycles - years, not days). The downside is that it's incredibly hard to find the bottom of a broad market disaster. We knew on January 17 that Carnival had hit its low, and that's quite a valuable piece of information. But when the broad market slides, the low is anyone's guess. On the other hand, "low" is good enough; you needn't nail the "very lowest" - at least, not unless you're prone to greed and regret!


Jojo the Hun said...

Still enjoying your slog-blog. Just wish to mention that situations where more harmful news is unlikely to be uncovered are, like bottoms, much more obvious in retrospect than in real time. There are certainly examples where a stock drops immediately after some event, and then continues to drop.

Jim Leff said...

Well, okay. So instead of saying "Watch out for situations where bad news may keep unfurling", would it have been better if I'd added "....and sometimes it's hard to be sure"?

I didn't consider that extra level of warning necessary, because, in the first place, obviously none of this is a sure thing. When Martha Stewart's verdict came out, it was pretty obviously a one-hit disaster, but, hey, a fire could have broken out at her office twenty minutes later. Or something. You never know.

But my point stands: if you're reasonably sure you're seeing a one-hit disaster, and that the company won't be driven to bankruptcy by the news, that's usually a smart investment, and I bet that if you did it every time, you'd turn a handsome profit.

I wish I had the skills and resources to do thorough research on this, but, besides the two clear examples I gave, my own informal observations over the years indicates that it 1. works, and 2. everyone else hasn't thought of it (because no matter how smart traders are, few are able to overcome their emotional flocking instinct). And that's a rare and valuable combination in an investment world where you might think everything this obvious has already been tried ad infinitum!

But, that said, nothing works 100%....

Jojo the Hun said...

Including your proposed warning still leaves the implication that sometimes you can be sure.

How do you operationally define "obviously a one-hit disaster"? It is easy to give a flippant reply, more difficult to construct a definition you can trade on. For any rule you come up with, it will be easy for you to go back later and critically poke holes in it, or you're just not thinking. The rule may end up reducing to something like "by using my judgement, which I am confident I can rely on".

You may find that you make a profit nine out of ten times, but lose so much in the tenth time that in balance your system loses money. It could usually be a smart investment, yet in the long run not be so.

Your inclination to research this idea is on track, and then testing is even more important. Based on my own work in this field, I'd say the potential for profit or loss for this or any similar idea mostly comes down to the way the idea is translated into formal, executable rules.

Jim Leff said...

Thanks for the reply, but you're tenaciously fighting a point I conceded, and ignoring my reasoning re: why it's not particularly germane.

Again, I acknowledge there is uncertainty in knowing if another shoe or two will drop in a given disaster. There's a long tail of uncertainty, and, yes, the type of trading I'm suggesting could go the wrong way if you don't get it right. And "right" is a crumbly thing in foresight, if not hindsight. Granted.

But even if you guess right, and a given disaster actually is one-pointed, you're STILL in a soup of uncertainty. What if the company's sector - or the broader marker as a whole - collapses in the week or two after the disaster? Or any of an infinite number of unpredictable factors that might foil this play?

The soupy grey area is always to be assumed in any investment. So if you want me to concede that this isn't a sure-fire moneymaker, fine!

None of this detracts from the value of my proposition that markets overreact, short-term, to disasters, and my observation that few contrarians seem to work this angle (per the stock charts re: the two massively publicized disasters I chose as examples). And that's opportunity.

Now....should you be extra selective - choosing only those relatively rare situations where it's a decent (though never certain) bet that additional news won't make a huge diff (the two examples I gave are good instances)? Perhaps. As in any trading scheme, one decides how conservative or aggressive to be. And one shouldn't expect to always get it right.

If you want to say that that conservative/aggressive decision is 90% of the game, and one's tolerance for getting it wrong accounts for another 5%, sure, I'll agree. But that applies to any investment strategy. And doesn't speak in any specific way to the one I'm suggesting here.

It's sort of like proposing a novel approach for buying unusually high value children's clothes and having someone argue back with the point that children outgrow their clothes anyway. :)

Jojo the Hun said...

I didn't mean to start an argument, and am sorry if my tone implied that. I think your idea is a good one. In fact, I started out trading with the same idea, and did well with that idea.

I agree that markets often overreact after an event. The scrutiny that comes after an event sometimes uncovers broad problems in the company or sector. From the perspective of an investor this additional bad news cannot be considered statistically independent of the original bad news, the way that the Martha Stewart verdict and a hypothetical fire could be. Some investors may automatically discount additional bad news, and thus underestimate the value of the company if no such bad news follows. My main point (and excuse me if you think I am being repetitive) was that I think it would be exceedingly difficult to quickly determine after a disaster that it is a one shot deal. You may think that it is not so difficult, and that's fine.

Jim Leff said...

Hey, what's wrong with an argument? I don't know when that became a bad word. I guess right around the point when people's level of giving a damn sunk beneath their tolerance for friction.

Everyone prefers to be around non-argumentative people these days (it wasn't always so!), but such people care - and give - less! So thanks for caring enough to engage in some friendly light friction, and offering the benefit of your thoughts and experience!

" would be exceedingly difficult to quickly determine after a disaster that it is a one shot deal. "

By the same token, there's no such thing as a purely one-shot disaster. Companies are always prone to errors and problems. Bad things happen, markets slide even when bad things don't happen. There's a continuum of FUBAR that never ends.

But if you'd invested in MSLO after the crash post-verdict, or in CCL after the sinking, you'd have made 10-15% within a week or two. Neither of those stocks crashed because traders were worriedly asking "Uh-oh....what ELSE is coming?" They crashed due to overreaction of clear, pointed news. I don't think it was "exceedingly difficult" in either case to see that, and I don't think either was so unusual a case.

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