From Stocks to Stonks!

The following article was published in the weekly newsletter by Fin-X dated July 28, 2020.

On May 23, 2020, Hertz, a 100-year old car rental company filed for bankruptcy. The stock traded at $20.3 on 20th February 2020 before falling to $0.56 on 26th May 2020, three days after it announced bankruptcy. But in a sudden turn of events, the price rose by nearly 10 times to $5.53 within a couple of weeks before settling around $1.5 in a few days. Sounds fascinating, no? Let's delve further!

As per a report published by Bloomberg on June 9th, 2020:

"I have always thought people have a psychological urge to buy stocks at a low price,” said Kirk Ruddy, a former bankruptcy claims trader. Retail investors may be buying big names they recognize without realizing how rare it is for shareholders to get anything back in bankruptcy, he said.

“If you look at the markets in general, people don’t know where to put their money. They are like ‘Hey, I’m going to try that $1 stock,”’ said Ruddy, who now works in sales for SC Lowy Financial HK Ltd.

[….]

Some of the rally in bankrupt shares might be attributable to short covering, when traders who have bet against a company close their positions by re-buying shares, lifting prices. But the rally could also be fueled by amateur traders, bored in lockdown and looking for a quick buck, using platforms such as Robinhood. The number of Robinhood users holding both Hertz and Whiting Petroleum shares surged after the companies filed for bankruptcy, according to Robintrack, a website unaffiliated with the stock trading platform that uses data to show trends.

As per the report, new Robinhood investors, who have signed up for the trading services either because of the market hitting new lows, or out of sheer boredom, or just for some entertainment, or even with the expectation to make quick profits especially when income levels are down, are buying into the stocks of bankrupt companies in huge numbers. The newly minted investors are trading in the stocks about which they might not be completely knowledgeable about.

While the stock prices increased 10x, the bond prices continued to trade below par, implying less than full recovery. As per the absolute priority principle, until the debt holders, who have senior claims on the assets of the company, are paid in full, equity investors are not paid. Is it possible that the debt investors could be overly conservative in their assumptions and consequently wrong, while the retail equity traders have higher expectations from the company based on their fundamental analysis? As it turns out, retail traders were indeed expecting a major turnaround in the company, which could have led to substantial gains for them. However, the chances of retail equity investors recovering anything in bankruptcy are next to negligible, with such cases hard and few.

Also, as we have highlighted in on of our previous articles, The Fault in Our Credits, the debt markets typically consists of institutional investors and the equity markets have higher retail participation, a sizeable part of which is day traders hoping to make quick money. As such, it seems unlikely that the retail investors would have conducted better fundamental research taking into consideration the corporate structure, the expected values, and the final payouts, especially for an entity as convoluted as Hertz. 

The shareholders who bought the stock near the highs of $5.0 did lose a substantial part of their investment as the stock price crashed, But the pinnacle of the problem reached when the bankrupt company came out with further issuance of shares. The debtors, who were managing the company during bankruptcy, tried to raise $1.0bn by issuing new shares of common stock. The retail investors, who were driving the stock higher, traded the available free-float stock amongst themselves. The debtors decided to make the most of the situation by issuing new stock to the same investors, which could have resulted in higher recoveries for the debtors at the expense of the shareholders. 

At the time of filing for issuance of new stock, the $3.0bn debt on the books of Hertz was trading at 40%, implying a value of $1.2bn or a loss of approximately $1.8bn on debt. It effectively means that if debt holders expected recovery of 40%, as per the absolute priority principle, there was no chance equity investors could have got paid, which means the value of equity shares would be zero. It also means that the value of the new stock, which would have been issued, would be near zero (if not zero) too. As per the prospectus, debtors were asking money from the potential shareholders, and it stated that the newly invested money would be employed to run the company during the bankruptcy process. In case the company indeed turns around, shareholders could make some money. But if anything goes wrong further (we wonder what could go wrong after the company declares bankruptcy), the cash available with the company will be first used to repay the debtors and new potential shareholders might not receive anything in return, the chances of which were very high (almost certain). Essentially, the retail shareholders would have offered their money to institutional debt investors with no chance of being paid back.

We do not know if the potential shareholders were indeed taken for a ride because SEC interjected at the right time. But it does not take away the fact that the retail investors, allured by the potential to make quick gains on their investments or for mere excitement, have ventured into the uncharted territory. Over the past few months, speculative excesses have increased multifold, companies with zero revenues are experiencing multi-billion dollar valuations and people have already lost enormous sums trading certain sophisticated-sounding negative and leveraged ETFs.

All is well till the markets remain in investor’s favor. Markets have seen liquidity-driven rally even when the economy is in doldrums and investors have hugely benefitted from the same. But when the tide turns, these retail investors could be the ones holding the bag of nickels, which they have perceived as gold. 

This brings us to question if higher retail participation in stock markets should indeed be preferred. Over the last few years, we have cried about low retail participation in India; indeed, in India, it is abysmally low at 2% vs 25-30% in the US. Deeper equity markets present significant benefits to not only retail investors in the form of high long-term inflation-adjusted return but also lead to lower cost of capital through a wider investor base. In the long term, if capital is allocated efficiently, both the providers and receivers of the capital benefit. So much so, until two years ago, in India, dividends, as well as long term capital gains on equity investments, were tax exempted. Clearly, the importance of equity markets for retail investors cannot be overstated.

However, do the retail investors really abide by the principle of long-term wealth creation? One of my favorite investors, Peter Lynch famously quoted ‘Invest in what you know’. Barring a few, how many retail investors would care to analyze financials of the company, understand its business model, and make an informed decision? Retail investors constantly look for next hot stock, they seek tips that might make them rich overnight, and they often get swayed by analysts on financial news channels. Little they realize that the steep fall in the price of the stock that keeps going up with every passing day might just be around the corner. As much as NSE would want the investors to ‘Soch Kar Samajh Kar Invest Kar’, how many would do so? In our article Raise Funds While the Sun Shines, we mentioned how Reliance is transitioning from a capital intensive oil & gas and telecom business to the capital-light payments, entertainment and IoT business, owning all the layers of the tech stack. We also mentioned that significant value from its new-age business is untapped so far and yet to be realized, making it a VC play, albeit with a robust execution strategy. But how many retail investors are capable to see the company beyond the traditional oil & gas and telecom business? For them, the company is in limelight because of the new investors that keep pouring money in the company every day, driving the stock higher*.

*We are again not providing investment advice on the company. Valuations might seem high, but Reliance does seem to be in the position in which it will be able to extract considerable value from the Indian consumer markets. But why would a company keep selling a portion of its crown jewel even after meeting the objective of going net debt free? I hope I confused you enough! 

India has experienced a trend of an increase in the number of investors over the past few years. The number of demat accounts has more than doubled from 19.0 million as of FY 2011 to 40.8 million as of FY 2020. While such growth could be attributed to demographics, we believe the emergence of discount brokers has had a significant role to play. Gone are the days of commissions to the tune of 4.5% and lengthy process to open demat-cum-trading-cum-bank account, filling tens of pages, often requiring as many signatures. As the cost to set up and maintain a brokerage firm reduced drastically, the number of brokers and sub-brokers increased considerably, leading to higher competition in the market. Fees have reduced to approximately INR 20 per trade and the whole documentation process has moved online and can be completed in less than an hour (1 year back when I transitioned to Zerodha, I had to send one document to their office; now probably that is online too). 

The technological penetration has made it considerably easier for retail investors to trade in the market. One no longer needs to be hooked up to the TV screen to check the price of his / her favorite stock and call up the broker to place the trade. With the proliferation of financial and trading apps, one can view, place and monitor a trade at a click of a button.

Just as the US is experiencing a boom in the number of new investors during the lockdown, India has not lagged. Since March 2020, 1.8 million new accounts have been opened. While it is heartening to see investors lapping up beaten-down stocks amid extreme pessimism, increased valuations amidst contraction in the economy have not deterred these investors ever since. Since March 2020 lows, nearly all the segments of the market, as measured by Nifty 50, Nifty Midcap 100 and Nifty Smallcap 100, have risen between 40-50%.

The new retail investors, taking advantage of free fall in the market, rode the wave and profited considerably over the same time period. As per the recent analysis by the Economic Times, retail investors have become smarter, relying on research and insights, utilizing tech for managing risk, trading low on margin, not falling for sunk cost fallacies and focusing on quality stocks.

But the jury is still out if the trend is sustainable. Much literature has been published around the bored, locked-at-home retail investors driving up the markets, both in the US and India. Even importantly, it is important to know if it is markets reaching new highs (from the historical lows) bringing new investors to the market or is it new investors driving the markets higher – with the limited research conducted so far, analysts are pointing out to latter. Till the time the circular loop feeds itself, everyone is happy. But as the economy opens, investors return to their jobs and do not have as much spare time as they previously had, will the music still be playing? One might argue the opening of the markets is better for the overall economy and that might push the markets higher. But the same was the story before the Covid-19 hit and except for a few large-cap stocks, the overall market was significantly underperforming. Unless the economy repairs structurally, the likelihood of which keeps going down as Covid-19 cases jump, it becomes increasingly difficult for the high valuations to sustain.

We are not overly pessimistic, and perhaps investing in quality large-cap stocks indeed seems to be a good strategy, helped by the theme of strong becoming stronger. However, the risks remain, and investors should be cognizant of the same. Especially in certain small-cap counters such as Ruchi Soya, where the recent rally of 8,818%, has raised suspicion and might soon come under investigation. Retail investors are increasingly dabbling in penny stocks. We do not advocate retail investors to shun the equity markets outright but perhaps seek professional help for the management of their investments. In such a case, actively managed diversified mutual funds or even index funds could provide requisite exposure and generate high inflation-adjusted returns without substantial risks. The risk comes down because of the diversification. However, investors seem to be doing exactly the opposite of that – SIP investments hit an 11-month low in May 2020.

All said and done, what could be possible solutions to prevent or limit losses to the retail investors? To be honest, we also do not know and while we could propose a few, we see demerits in all of them. Brokers require certification in equity markets to become eligible to provide their services. Historically, stockbrokers have acted as an intermediary – executing the trades once they receive confirmation from the clients, possibly providing guidance in the process. One could argue that stockbrokers do not always act in the interest of their clients, but in a relationship-driven role, they have got strong incentives to do so. However, in the contemporary times, stockbrokers have become platforms – they no longer interact with the client; instead, the client can easily trade on the stocks they wish to with a single click, removing any scope of guidance (except for the few apps that are educating the investors through different means). Should we make certification mandatory for every investor? Unfortunately, that would not yield material results – markets and stocks are much more complex than what the 100 odd questions can capture and it takes more than just an exam to gain sufficient knowledge of the markets. And who says people without formal education cannot make a killing in the market?

Sebi came up with the regulations a few years back in which it classified mutual funds on the basis of the level of risk – blue, yellow and brown. It simply divided the debt, hybrid and equity funds into these categories. Can we follow the same principle for the stock markets? We do not think so – there are various ways in which you can assess the risk of a stock and one formula can never be applied.

Next, should you limit participation in the stock markets on the basis of income? And if so, should such criteria be applied to all the stocks at an aggregate level or handful of riskiest stocks. In both cases, there would be outrage in the name of limiting retail participation and depriving markets of much-needed capital. The public markets will be compared with the private ones, where such restrictions exist, possibly questioning the role of SEBI in the process. In case you limit it to a few stocks, as highlighted above, how would you identify the riskiest ones? And in case you manage to, will those companies accept that?

We hope a policy thinktank is able to come up with a solution soon, or else we would be staring at the scenario in which shareholders demand the bankruptcy law be changed to prevent total wipeout of their investments.