After a rough start to the new year, a lot of investors might be tempted to buy into “fallen angel” companies at or near all-time lows. They’re not hard to find. In the tech sector, GoPro and Fitbit, two profitable and recently public companies, have taken major hits. GoPro is down 90 percent from its all-time high. Fitbit has lost two-thirds of its peak value. Another sector where investors might be looking to buy low is energy, where scores of service and exploration companies are down 90 percent or more. Established names like Denbury Resources, Forbes Energy, Gastar Exploration, Basic Energy, Bill Barrett, and Ultra Petroleum, among others, have all been creamed, and could seem like bargains.
All I can say is: buyer beware.
As far as GoPro, Fitbit, and other beleaguered tech stocks are concerned, anyone thinking about buying them should ask a basic, but extremely important question: will these companies exist in five years? There is a chance the answer to that question is no. And even if they do survive, how likely is it that they will enjoy a meaningful stock price recovery? The best-case scenario for GoPro and Fitbit could very well be that their stocks trade sideways for the foreseeable future before a larger business acquires them at a modest premium. The worst case? They disappear entirely, wiping out their shareholders.
Energy is an even riskier proposition. All of the companies I named, and many more in the space, are choking on onerous debt loads. The bond markets know this. The high yields on each company’s bonds are strong indicators that many of them will chapter out before the price of oil has a chance to recover.
If you think I’m being overly pessimistic, I recommend an eye-opening 2014 report (PDF) by JP Morgan Asset Management analyst Michael Cembalest titled, “The Agony and the Ecstasy.” Cembalest’s analysis shows that a shocking number of stocks not only go down, they stay down:
Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70 percent plus decline from their peak value. [emphasis added]
Consider that statement for a moment. Over time, four in ten stocks lose almost three quarters of their peak value—and never recover. And that’s not the only grim finding. The median (note: not mean) stock massively underperforms the index:
The return on the median stock since its inception vs. an investment in the Russell 3000 index was -54%
This report should be mandatory reading for both institutional and retail investors. Yet it was hardly mentioned in the financial press after its release. It should also be mandatory reading for short-sellers, because the lessons it imparts are just as valuable on the short-side as the long.
During 25 years managing a long/short fund, I have watched scores of companies file bankruptcy and go to zero. Yet most short-selling funds—maybe all—have terrible track records. Famous New York short seller Jim Chanos’ Kynikos fund is reportedly down over 80 percent since inception. The largest public short-biased fund, Federated’s Prudent Bear Fund (ticker BEARX), is down 75 percent over the last 18 years. Why? Because most short-sellers try to uncover frauds and accounting scandals like Enron and Worldcom—and that is a terrible way to make money.
Finding and profiting from crooked businesses is incredibly hard. For every accounting fraud, many, many more companies simply fail. Restaurant chains Boston Chicken, Chi-Chis, Planet Hollywood and Koo Koo Roo all filed bankruptcy since I started my fund; as did retailers Circuit City, Bombay, Blockbuster, Sharper Image and Kmart. Failure among public technology companies has been widespread, as well. According to Cembalest’s report, energy, information technology, and telecom stocks have the highest failure rates. Since 1980, roughly half of Russell 3000 stocks in these three sectors dropped 70 percent or more from their peak and never recovered.
Looking back, it’s easy to see why most of these stocks lost value. Too bad hindsight isn’t a great investment strategy. Great investors like Warren Buffett take a clear-eyed measure of where a business is likely to wind up several years in the future. What makes this so hard, as Cembalest writes, is the excessive optimism that permeates Wall Street and corporate America:
While the losses on the stocks in our case studies may seem obvious or inevitable with the benefit of hindsight, in all likelihood the company’s management, its board of directors, research analysts, credit rating agencies and its employees all firmly believed in its long term success.
I’ve witnessed this optimism bias at countless troubled companies over the years. And, as I’ve written before, one of my hobbies is collecting outrageously positive reports from Wall Street analysts. My favorite is a strong buy recommendation from a prestigious brokerage for Planet Hollywood dated one year before it filed for bankruptcy. Much like GoPro today, Planet was supposedly “building a brand.” Investors picking through the wreckage of the markets today would be wise to consider that failed logic, as well as the lessons of Cembalest’s report.