Zero-Return Failures – Part five of a short series on Charlie Munger’s Human Misjudgment Revisited.

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“More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.” – Phil Fisher

Some of the greatest value investors in history, including the likes of Warren Buffett, Benjamin Graham, Walter Schloss and Irving Kahn, made millions from investing in bankrupt securities. These audacious trades help cement these investors as some of the greatest in history, but for every great trade, how many other investors lost everything?

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Zero-Return Failures Are All Too Common

Investing in bankrupt securities is a high-risk game that requires plenty of conviction and rigorous research. And even if you spend hours trying to understand each opportunity, there’s no guarantee you’ll make a return. In fact, the odds are stacked against you.

“[B]etting on these stocks on average generates substantial losses… Our sample’s median matching-sample-adjusted monthly return is -15%, and market-adjusted monthly return is -14%. The negative abnormal returns do not cluster in a particular year but persist over time. In addition, this finding is…an indication of the poor performance during the Chapter 11 process, which can last from a few months to a few years. It is surprising that investors lose so much money investing in Chapter 11 stocks, even given the fact that shareholders are residual claim holders in bankruptcy. Thus, the finding that Chapter 11 stocks underperform indicates the existence of market frictions. Our explanation for the negative returns is motivated by the Miller (1977) theory, which argues that, when investors have heterogeneous beliefs about the value of a risky asset in a market with restricted short-selling, prices will reflect the more optimistic valuation. After Chapter 11 filings, these stocks are mostly traded on Pink Sheets, which does not require information disclosure to investors. Meanwhile, as the stock ownership data shows, institutional investors dramatically reduce their stock holdings around bankruptcy filings, and more than 90% of the shareholders post-filing are individual investors. Many analysts stop covering these stocks due to the lack of interest from institutional investors. Individual investors are presumably less efficient in gathering information and interpreting the available information (Barber and Odean, 2000). Therefore, the information uncertainty and the divergence of opinion regarding the true value of these stocks increase dramatically after filing. In addition, low institutional ownership produces binding short-sale constraints for these stocks. As a result, the high information uncertainty and binding short sale constraints cause bankrupt stocks to be overvalued.”

The above extract is taken from Philip Ordway’s Charlie Munger’s Human Misjudgment Revisited, which borrows from this study (Investing in Chapter 11 Stocks: Trading, Value, and Performance). According to this study on Chapter 11 scenarios, most retail investors in the up losing everything when trying to pick the best bankruptcy lottery tickets. Institutional investors fair better as they usually invest higher up the capital structure, where the risk/reward skew is better, and they have additional creditor protections.

2017 SALT Conference, Zero-Return Failures
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The retail investors who end up holding the bag find themselves absorbed by prospect theory, a similar psychological trait to that which affects compulsive gamblers.

“The machine zone,” is trancelike state manufactured by the gambling companies. Video gamblers want “disassociation” and talk about “numbness or escape” or “climbing into the screen and getting lost.” These gamblers are not so much worried about winning but just playing the game. If this “machine zone” did not exist, and they truly understood the odds, would they still play the game? It’s unlikely.

Chapter 11 speculators have been lured into a game where there have been a few winners, but there has also been an overwhelming amount of zero-return failures. It’s not just the gambling compulsion that’s at work. There are often many factors at work in concert, all of which add up to convince the retail bag holders that they’re making the right decision, as Ordway explains:

“There is often commitment and consistency, social proof, mis-gambling compulsion, and other factors at work in concert. They’re not just violating absolute priority and ignoring base rates; they’ve been lured into a game with an overwhelming amount of zero-return failures but a few home-run or lottery-ticket profiles that create bias from extra-vivid evidence. That happens in other option-like asset classes and in real lotteries, of course.”