Wednesday, December 11, 2019

Momentum in equities when reputational risks are high

This blog originally was supposed to mostly be about investing tactics, but I got sidetracked when I discovered the housing issue that has ended up taking over.

Here is a post on the topic I used to dwell on - tactical investing for high returns by being insensitive to reputational risk. A recent example of this issue is Hovnanian Enterprises, a major homebuilder that is still so down on its luck as a result of the housing bust that as recently as July, it was being threatened with delisting from the NYSE.

All along, they have mostly just needed the market in new housing to recover.  They need revenue to fully regrow back into the financial and organizational framework that had developed under the Hovnanian name in 2005.  They have so much organizational and financial leverage that small increases in revenue will translate into large increases in market capitalization.  This will further be enhanced by knock-on effects of recapturing the value of tax assets and written down developments, and paying or refinancing debt at more favorable terms.

After the July delisting notice, Hovnanian released results of two quarters which have provided strong evidence that revenues will be growing and these positive developments will be coming.  Normally, efficient markets would internalize these developments immediately, and a firm's share price would immediately jump to a level reflecting the new expectations.  Financial research has shown a momentum effect.  In other words, a trend in share prices doesn't happen 100% at once.  It mostly happens at once, but there does appear to be some predictable serial correlation.  A recent trend shift or a recent positive or negative shock to a share price will tend to continue in the short term, to a certain extent.

But, in unusual positions where reputational risk has become acute, this momentum effect can become very large.  I am sure there were some institutional holders who were forced by their own rules to unload shares when Hovnanian received the delisting notice.  At some point, the reputational danger of having owned a stock or of recommending a stock, can overwhelm the objective value of it.  In these cases, the market for that equity becomes very tepid.  It's sort of like very thirsty wildebeests coming upon an oasis.  They very understandably approach it carefully at first, not sure if it is safe.  But, almost inevitably, the whole herd will be lined up at the shore, sucking up water vigorously.  To someone who happens to have been at that oasis when the herd showed up and recognizes already that there are no crocodiles, this process can seem excruciatingly slow.

Here is the Hovnanian stock chart from the past 6 months.  The positive shocks are noticeable after each quarterly announcement, but even those shocks took place over several days.  Following the initial quarterly shock, there was further upward drift for some time.  The more recent positive shock also took several days to play out.  It will be interesting to see if a positive drift follows this shock also.  If revenues do climb from here, the share value is likely many times the current market value.  Getting from here to there will reflect a combination of objective results, expectations, and changing reputational risks.  It is the implicit position on reputational risks that can provide very high returns over time, but it comes with the occasional risk of losses, and those losses will necessarily be devastating and embarrassing.

Source

5 comments:

  1. Great stuff. I think this one great way to pick stocks, and that is buying what is offscreen for institutions but may get back on.

    https://www.zacks.com/stock/chart/SHG/fundamental/pe-ratio-ttm

    Financial are down, Korea is off, the Sino-US trade issue is giving the jitters. This bank group seems way too cheap. I don't know enough yet....

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    Replies
    1. I think you're right. The individual positions have very fat tails, but there is potential for positive net returns.

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  2. https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1207341

    I don't know if you will be able to see this.

    The Hovnanian CDS spread is declining, reports Moody's. To 1,269 from 1,373 in one week.

    I guess that is a good sign. Bonds rated Caa3.

    ReplyDelete
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