Low Quality Investing, Pt. 3: The Trend is Ending in Tears

“I don’t know how you could be not telling people to buy AMC, Gamestop, Nokia, etc. right now.” I’ll never forget being told this last year, when Low Quality Investing was reaching its zenith. I wrote it about it at the time on this blog in a state of melancholy, both dreading and hoping for the end of the “low quality investing” trend. I do not like to see people suffer, but I also do not like it when bad ideas to dominate markets for information that have so much potential- there is no reason in 2022 for bad analysis of data to carry the day. The people who have lost so much in search of low quality outperformance are, in my opinion, victims of predatory marketing by unqualified actors giving very bad advice. If you haven’t read my other articles on the topic, I suggest you read those. 1 2 

That day of reckoning has more or less come with as much hope and dread as a trend can carry. It is truly ending in tears as low quality investing has left true believers a great deal under water this year. There are a few different angles to look at that through. One of them is the poster child of low quality investing: AMC stock.

Now, I know that as much as I have stressed the fact that I believe the fundamentals of this stock are existentially bad- as in, the company may not be long for this world- many people who read this blog have bought the stock anyway. What I don’t mean to do is say “I told you so.” I’m using AMC as an example because it was held up as an entirely new type of investment thesis. If I had to summarize that thesis (my apologies if the description is overly uncharitable): investing based on fundamentals is wrong and misguided because crowds of people can readily uproot a stock from the financial realities of a being an actual company and be lifted on the shoulders of a crowd toward financial outperformance of broad markets. “Flows over pro’s” was the rallying cry, an entirely new “theory” of investing.

Luckily, financial theories are proven right or wrong in ways that are difficult to deny even for those with the most to lose for being wrong. The theory that AMC could reach “escape velocity” with enough no-strings-attached cash from investors is one such theory- AMC fell short of “going to the moon” and is being vaporized on its re-entry into the atmosphere of financial reality. As of today, the stock is down 60.9% Year-to-Date.

While AMC is without a doubt losing credibility among investors for any number of reasons as its share-price collapses, it is far from the only low quality stock to attract big dollars from the investing public.

There are two “Indexes” of stocks I’ll draw you attention to in looking beyond the AMC fiasco for evidence of low quality stock relative-strength: the Roundhill Meme Stock ETF (ticker: MEME) and the Direxion Falling Knives ETF (ticker: NIFE). Both of these indices and their ETF exemplars have suffered catastrophic losses this year, with MEME down 56.8% Year-to-Date as of today and NIFE down 32.6%.

The Roundhill Meme ETF has been hardest hit mostly because it has an extraordinarily low Quality Factor score in a year where Quality has slightly outperformed the market thus far- MEME has a Quality Factor score placing it in the bottom 1.15 percentile of the market in terms of weighted financial health of the underlying stocks. It would be hard to find a more perfect example of low quality investing, as well as a better example of why low quality investing is a bad idea. It has performed about 40% worse this year than ETF’s focused on the highest quintile of Quality in financial health- for example, it is down 40% more this year than the Invesco Quality Factor ETF (SPHQ).

Included in the MEME portfolio are Rivian, DraftKings, Tesla, Roblox, Tilray, and of course AMC itself. AMC is one of its best Year-over-Year performers at this exact moment.

For MEME, the weighted average Cash Flow growth of the portfolio’s underlying holdings is a shockingly bad -34%. This fact should give the fund’s investors a lot to think about. For reference, even in this difficult year for companies, the category average that should serve as the Fund’s benchmark according to Morningstar has a Cash Flow growth of 16.30%. There is a 50% gap between the portfolio’s fundamentals in terms of Cash Flow growth and the category average.

NIFE may look better by comparison, but it is by no means in good health. In fact, when it comes to Quality Factor scores, it is in the bottom 0.03 percentile. It doesn’t get much lower quality than this fund. One thing that appears to be buoying NIFE above MEME from my read is that NIFE is more “diversified.” It has nearly twice as many stocks (49 compared to MEME’s 25 stocks). A couple of the higher weighted components of the index are not as “falling knife”-ish as one might suspect, with the top 3 holdings (nearly 20% of the portfolio, which happens to be a high concentration risk going forward) have only lost as much as 15% this year. That’s actually not too bad given the broad market’s performance. Much of the portfolio has not been as fortunate, dragging it down to the 36% loss the ETF has returned Year-to-Date.

By comparison, the Russell 2000 -which indexes a large slice of America’s smaller publicly traded companies- is down 24.3% and the NASDAQ index (I’ll gauge that by its most liquid representative, the QQQ ETF) is down 27.4%. NIFE has managed to lose substantially more than America’s current most volatile broad based indices and 20% more than Invesco’s Quality Factor ETF.

The rise of low quality investing was relatively swift in terms of investment theories. Very little came out from academics in finance to support low quality investing. There were plenty of think-pieces in journals that are broadly skeptical of Capitalism such as Vox.com, Salon, MSNBC, and countless TikTok and Instagram accounts. That is, the “evidence” that low quality investing was a good investment theory never really materialized even as the trend ballooned in terms of participants and in terms of total assets flowing into low quality stocks. At the end of the day, most of the Media supporters and hype-artists around low quality investing as a trend were merely using it as a new tool to attack Capitalism. The good news for the Vox & Salon’s of the world is that one can even more readily bash Capitalism with a failed Meme Stock revolution as one can with a nascent Meme Stock revolution- I await the coming lamentations over this failed rebellion anxiously (lest I have to write them all myself!).

As I wrote in my last update on low quality investing, this theory morphed into a “narrative” driven idea, and that was always dangerous. Narratives can motivate people to do things that they think they understand when they really don’t, and that’s the problem with relying on them for investment theses. Look no further than the various phases of war propaganda from any country in the past 100 years for good evidence of this.

The thing investors need to learn from low quality investing, whether they lost money following this trend or simply have enjoyed reading my occasional updates on this blog about it, is that narratives and descriptions are profoundly different from each other. Classical asset pricing theories and Capital Market Assumptions approaches are descriptive in that they collate data, analyze it, and at least attempt to describe it. An investor’s confidence in these theories should map to the quality of description- logical leaps, non sequiturs, and faulty premises should cause skepticism. By contrast, narratives are just stories. At best, they attempt to project what is possible and are grasped by hopes looking for something to latch upon. At worst, they are misdirections or outright lies. Narratives can draw attention to all of the wrong facts in an attempt to build confidence.

All along, the low quality trend has been a savvy campaign by a wide range of market participants to build confidence in companies that rational markets should approach with skepticism. Deteriorating credit conditions, weakening balance sheets, falling Cash Flow growth, compressed margins, and toxic assets all should arouse suspicion and cause market participants to discount the futures of companies showing signs of these instabilities. The basic reason for existence of markets given by classical economists has been in fact this task above all others- markets are dynamic scales of dynamic information. Ignoring information is something markets do at their own peril.

My hope is that the current market experiences of low quality investments is a sign of a sobering market- one that is vigilant about fiscal well being of companies and reasonable in its estimations of future prospects for firms that wave red flags in their public disclosures of information. My hopes have often been frustrated in regards to market sanity around unwell companies over the course of the last decade. Yet, in a way, I am more hopeful to day of this possibility than I have been in many, many years. And hopefully that itself is good news to you in a time of mostly bad news for markets thus far in 2022.