The Rise of Low Quality Investing- Catching the Falling Knives

Hertz stock started going down fast recently when rumors of the company’s imminent bankruptcy freaked out shareholders. This only makes sense. One of the things that really should cause a stock to decline is imminent bankruptcy. This was all proven to be not at all hypothetical or rumor-mongering on Wall St. when Hertz filed for Chapter 11 Bankruptcy on May 22nd. 2

Oddly, a very large number of retail investors (investors with their own self-directed brokerage accounts) started buying the stock at rates which shocked analysts. Over 60,000 accounts on the Robinhood smartphone trading app purchased the bankrupt stock after Hertz filed for Chapter 11. By now, that number’s up to around 170,000. 3

As Chaim Investment Advisor’s own Pablo Lasha and I discussed in an episode of our Podcast a few of weeks ago (4), investors excited by the idea of buying something below what they thought possible bought up shares of devastated Oil ETF’s frenziedly. Namely, the ETF known by its ticker, USO.

People rushed into that one with no thesis whatsoever in many cases. In the end, the experience was negative for many first-time commodity traders. Hundreds of thousands of people who had likely never considered the sprawling calculus behind the price of oil were shareholders of a failing Exchange Traded Fund that didn’t technically own a drop of the stuff directly. Investors who did not even know how the fund was structured were slapped by the Broker to the fund with a refusal to do business with the fund as they had in the past. 5 The fund had gone from 10,000 investors on Robinhood to over 220,000 in the space of a few trading sessions when it fell to its lowest point, only to lose nearly 80,000 in a single day. (6)

To capitalize on the sudden zeal for low quality, bankrupt and failing companies with collapsing share prices, Direxion funds decided to launch an ETF called Fallen Knives ETF (ticker: NIFE). 7 To me, this sounds fairly cynical. A stock’s share price simply going down is not an actual indicator that it is worth anything at all. Precipitous falls, like that of Hertz, are often actually warranted. When the very ability of a company to operate and at the very least pay its creditors is in doubt, what reason is there to be excited to become a shareholder?

Nonetheless, Direxion’s fund is less “knifey” than certain investors might prefer. Looking into both its actual current holdings and its Prospectus, the fund’s objective is to buy shares of companies that have had a steep share price fall but are believed by analysts to possibly recover. From their marketing material for this fund: “The Direxion Fallen Knives ETF aims to deliver a simple, systematic approach to capturing stocks that have fallen significantly, but with the financial health to support future outperformance.”

Buying a company that is worthless for anything less than zero is not actual value hunting. Value Investing is a constellation of philosophies and approaches to portfolio management that believes in common in buying Equities for a good bargain. Some feel that this gives investors a “margin of safety,” such as Seth Klarman. (8) Others believe that it’s the easiest way to reasonably expect a given return. (9) For example, a Value Investor might argue, buying a stock at a 20% discount to its intrinsic value is an easier way to net 20% returns than buying something at its fair value and hoping it goes up for some other reason. Of course, arriving at an intrinsic value is the hard part.

At the end of the day, investors who lack a process of determining intrinsic value are probably not actual value investors. Sometimes, stocks that trade for a single penny a share may be expensive if the company’s worth less than nothing. Such stocks are not value stocks- they’re overpriced stocks with a low share price.