Self-Predicting Markets

by eapache1 min read10th Jun 202020 comments

27

Financial InvestingWorld Modeling
Frontpage

[Confident but not novel. Cross-posted from Grand, Unified, Crazy.]

The story of Hertz has fundamentally changed how I view the stock market. This isn’t a novel revelation – now that I understand it, I’ve seen the core insight mentioned elsewhere – but it took a concrete example to really drive the point home.

The short version of the Hertz story is that the company went bankrupt. They have nearly $20 billion in debt, and as far as anybody can tell, no path to recovery; they’re bankrupt because their business model has been losing money for years despite several attempts to turn things around. The twist? Their stock is still trading, and at time of writing they have a market cap of $900 million.

I notice I am confused.

On any intuitive understanding of the market this shouldn’t be possible. The company is literally worthless. Or really, worse – it’s less than worthless given its debt load. People are paying positive money to own negative money. On a naive view this is another nail in the coffin of the Efficient Market Hypothesis.

After noticing that I was confused, I tried to generate hypotheses to explain this story:

  • Maybe the EMH really is wrong and the markets are nonsense.
  • Maybe bankruptcy laws are so complex and tangled that the expected value of the company really is positive after all is said and done.
  • Maybe the markets expect Hertz to get a government bailout for some reason.

Some of these are plausible (in particular the second), but none of them were particularly satisfying, so I tried asking myself why I, in a hypothetical world, would buy Hertz stock in this situation. I gave myself the standard answer: because I expected the stock go up in value in the future. Then I realized that this answer has nothing to do with the value of the company.

I had been making the mistake of viewing the stock market as a predictor of company value over the short-to-medium term, but this isn’t true. The stock market is a predictor of itself over the short-to-medium term. If people think the stock will go up tomorrow, then the stock will go up today – it doesn’t matter what the value of the company does at all. The company can be literally worthless, and as the Hertz story proves, people will still buy as long as they think the stock will go up tomorrow.

Now in practice, there are a bunch of traders in the market who trade based on the expected value of the company. As long as these people have a majority or at least a plurality, then everybody else is destined to follow their lead. If the expected value of the company goes up, then the expected value of the stock goes up, as long as enough people are trading based on company value. But in cases like Hertz, the expected value of the company is nothing, so value-based traders exit the market entirely. This leaves only the "shallow" stock-based traders, whose rational move is now to trade based on the expected value of the stock being completely divorced from reality.

The market is really weird.

27

19 comments, sorted by Highlighting new comments since Today at 1:50 PM
New Comment

There's one additional hypothesis, and I say this in solidarity. Maybe we don't fully understand how to evaluate Hertz's underlying value.

  • In fact, as of today (6/10/2020), their market cap is $358.58 million, not $900 million.
  • Their debt/equity ratio is about 14:1, about 9x higher than the S&P500 average of 1.5:1. But Moody's, Lamb Weston Holdings, and Lowe's Companies Inc are on the S&P 500 and have DE ratios of 10 or 12 to 1.
  • Their net profit margins have been alternating between +/- 5% for years, so the current losses are nothing out of the ordinary. Maybe investors assume this is a great time to buy low.
  • Lots of major companies have recovered from bankruptcy.
  • They have intangible assets: organization and brand name recognition.

These are just some stats I threw together having zero prior knowledge about Hertz and no actual experience in picking stocks. But when I look at that picture - a global brand in a rough patch, with high but not unprecedented debt vs. equity, and very low stock prices - it's not obvious to me that it is misvalued by the stock market.

Note that I'm not saying it is correctly valued - just that it's not obvious to me that it's incorrectly valued. "Nail in the coffin of the EMH" is a fun phrase to say, but as always, the bottom line is that if you're so sure, why aren't you shorting Hertz?

“Nail in the coffin of the EMH” is a fun phrase to say, but as always, the bottom line is that if you’re so sure, why aren’t you shorting Hertz?

Because the market can stay irrational longer than you can stay solvent. It's entirely possible that Hertz is incorrectly valued, but if you short Hertz now, then you had better have enough liquidity to survive the margin calls caused by irrational exuberance.

One additional point that should matter. The valuation is not merely Hertz as an enterprise but the value of Hertz's assets to other market players. If Hertz is gone then the market equilibrium shifts for all the other rental companies. What is the value of merger (friendly or not)?

A merger where the merging company gets $20 billion in debt likely isn't worth it. 

They have intangible assets: organization and brand name recognition.

This is super important when talking about value decided by markets independently of the asset that backs it.

People will pay lots of money for objectively near worthless purchases because they choose to value them.

I just got around to actually looking at Hertz' most recent financials. Short version:

  • $19B of debt
  • $26B of assets, mostly highly illiquid (e.g. cars, property)

So this bankruptcy is not a situation where the company has negative net value, it's a situation where the company doesn't have the revenue to cover its debt-servicing costs in the short term, because their assets aren't liquid. But the company's assets are still worth substantially more than their debt, so it seems reasonably likely that stockholders will still end up with a fair bit of value. Indeed, assuming Hertz isn't forced into a fire-sale, their assets are (supposedly) worth $7B more than their debt, and their market cap is only $900M as of the OP, so there's an awful lot of space for good things to happen there just based on fundamentals.

The market is really weird.

The EMH is only true at a zero-th approximation. There are many reasons why arbitragers cannot fix wrong prices, see e.g. "The Limits of Arbitrage" by Schliefer. There is a whole literature on this, not all of which is valid. Keynes said that markets can stay wrong longer than you can stay solvent.

All this suggests that prices can vary from value, but that it may not be too easy to make money from this insight.

I don't know the specifics of Hertz but very low stock prices tend to reflect the option values inherent in the asset. There might be a possibility that a Venture capital fund may want the stock for some reason. Even small possibilities, of large payouts, can move the price.

There is a lot more to finance than first appears. In the book series "market wizards", several traders comment that they have read hundreds of books on the topic, on top of their own research. My own experience over almost 40 years is that it is at a degree of difficulty similar to learning physics to an advanced level, and on top of that it is very challenging psychologically.

very low stock prices tend to reflect the option values inherent in the asset

+1 to this specifically. There's no way for Hertz' creditors to charge stockholders money (other than what they paid to hold the stock), and there's a nonzero chance that Hertz somehow ends up being worth something, so it would be an arbitrage opportunity in the strongest possible sense if Hertz' shares were actually priced at $0.00. The value must be strictly greater than zero at the very least, although it's not at all clear that it should be as high as it is.

As Benjamin Graham put it:

in the short run, the market is a voting machine; in the long run, the market a weighing machine.

Hertz corporate bonds are trading at 39 cents on the dollar so the equity is 99%+ to be worth 0. The reason the equity is trading above 0 is that there's a borrow fee so to short the shares you have to pay a borrow fee. Also there's legal implications of being short the shares throughout the bankruptcy process which might reduce the liquidity of your position or ability to get out.

It seems a lot of retail traders bought Hertz shares without understanding that they are going to end up worth nothing. Probably there should be some regulations added to prevent retail traders from making stupid investment decisions like this. Was similar when they bought oil futures close to $0 and then oil futures went negative and they got crushed.

Hertz is a big company. It has a yearly revenue of US$9.779 billion. If there's a 10% chance that Hertz gets rescued and becomes a stable company it might be wroth US$9.779 billion or more. If that chance would be 10% that justifies the $900 market cap. 

because their business model has been losing money for years despite several attempts to turn things around. 

They had a positive net income in 2019.

Whenever we try to evaluate whether the market is/was efficient in a particular situation, I think looking at the option chain is a good idea. Since you can extract an implied probability distribution, it gives a lot more information than the stock price alone.

We have to remember that businesses don't go bankrupt because they're unprofitable. Businesses go bankrupt because they're unable to make payments on their debt. The two are related, but not identical. It's possible that Hertz, as a company, is fundamentally solvent, but was caught out by a combination of high debt load and a sudden shortfall in cash flow. We've seen the same with airline bankruptcies in the past. The business can be fundamentally profitable, but a combination of thin margins and high capital requirements means that any sudden shortfall in cashflow means bankruptcy as the business is suddenly unable to make payments on the loans that it has taken out. The bankruptcy process (Chapter 11 bankruptcy protection) is designed to give legal protection to a business so that it can renegotiate its loans and emerge as a functional business without being liquidated.

I haven't run the numbers on Hertz myself, but it did seem to be a profitable business before the coronavirus pandemic caused all travel to basically go to zero. It's entirely possible to think that, at some point, the pandemic will end, and at that point people will want to start traveling and renting cars once again. Buying Hertz shares now, when they're almost valueless, is a cheap way to bet that a recovery will occur.

Allow me to present an alternative/additional hypothesis:

https://www.reddit.com/r/wallstreetbets/comments/h0daw4/this_is_the_most_autistic_thing_ive_seen_done_by/

The market is only as smart as the people who participate in it. In the long run, the smarter agents in the system will tend to accrue more wealth than the dumber agents. With this wealth they will be able to move markets and close arbitrage opportunities. However, if an army of barely litterate idiots are given access to complex leveraged financial instruments, free money, and they all decide to "buy the dip", it doesn't matter what the underlying value of the stock is. It's going up.

Not to say that what you're saying doesn't apply. It probably exacerbates the problem, and is the main mechanism behind market bubbles. But there are multiple examples of a very public stocks going up or getting a large amount of attention, and then completely unrelated companies with plausible sounding tickers also shooting up in tandem.

This only makes any sense in the world where the market is driven by fools eager to loose all their money or more.

In the long run, the smarter agents in the system will tend to accrue more wealth than the dumber agents.

Only if the smarter agents also have similar amounts of capital as the dumber agents. As Delong, Shleifer, Summers and Waldman showed, dumb agents can force smart agents out of the market by "irrationally" driving market prices up or down far enough to exhaust the limited capital reserves of the smart agents.

I'm getting 404 on that link. I think you need to get rid of the period.

Thanks, edited.

[+][comment deleted]6mo 2