The Private Equity for Families Blog

Losers Get Indexed Too

A January 9, 2020, Wall Street Journal article by James Mackintosh entitled “Money Losing Stocks Mushroom Even As Stocks Hit New Highs” cautions about the high percentage of publicly traded stocks that show three years of losses but still are experiencing significant price appreciation. Here is a chart from his article showing smaller stocks are a large percentage of the sample:

It seemed impossible to me there could be such a large percentage of losers, but when your market cap cut off is only $10 million there will be a large number of venture companies.

Microcaps Are Soaring With Wax Wings

I have written before about checking small cap public market peers to see if PE valuations are appropriate. My latest check , however, showed a stunning disregard by investors for fundamentals among the smallest participants in the public market! This is a new development and the anomaly forced me to do my own research about what is happening.

I looked at all public companies trading on major US exchanges with revenues greater than $75 million, net income less than zero in the most recent fiscal year, and stock price appreciation greater than 15% since January 2017.   I was surprised that more than 1,652 companies had losses, and even more surprised that 20% of those losers still managed a 15% stock price increase since January 2, 2017!!!

I then asked the question whether indexing and consistent equity inflows could be responsible for the stock movements.

No Price Discovery – Just Momentum

From the sample of 320 companies I looked at 17 companies I know and examined a few of their fundamentals like revenue, EBIDTA, and net income over a 5-year period.   I also looked at the average daily trading volume over that 5-year period, and the change in the holders of the stock.

One of the companies, let’s call it Beta, a software provider, has Cleveland roots so I dug deeper to see what was happening to its stock.

It shows a little growth in revenue since 2016 (4.7% CAGR), negative EBITDA, and negative Net Income.   There are few analysts who follow the stock.   Nonetheless, its shares have appreciated from $10.83 to $26.23 over that 5-year period for an impressive 19.53% compounded annual return.. Those are competitive Private Equity returns for a 2016 vintage year. It would be like CapitalWorks buying a portfolio company with losses and then selling the same company 5 years later without having eliminated any of the losses, but still getting a return of 2.4x our original investment.

I then looked at Beta’s average daily trading volume over that 5-year period. The volume in March 2016 was 206,000 shares a day.   The average trading volume for the twelve months ended 9/30/19, was 652,000 shares, and during that period the largest increase in ownership was Blackrock which doubled its position.

Losers Become Winners With Index Momentum

I began to wonder whether the disconnected price appreciation was simply the persistent flow of capital into index funds which, in turn, deploy the capital into the proxy portfolio irrespective of financial performance? I was surprised Beta is a member of more than 350 separate “software and services” or “information technology” indexes. These indexes contain leaders like Google, Microsoft and Amazon and have more momentum than Bernie Sanders with millennials.

In fact, I found where a company has persistent losses there is strong correlation between trading volume and price appreciation. Passive investment vehicles like index funds don’t appear to be using any fundamentals to select their index components. This is a big difference from mutual funds selecting components on the basis of fundamentals. As a result many companies whose stock price would have withered with persistent losses find impressive returns for simply being included in an index with momentum.

What Happens When Flows Reverse?

I then wondered how these persistent losers would perform when the capital flows reversed? So I looked at the most recent mini crash in December 2018, when interest rates were spiking and the Fed was shrinking its balance sheet. Sure enough, my universe of losers had dramatic stock price reversals ranging from 10-35% over a matter of weeks.

I am just not confident the arbitrage mechanisms built into the index fund pricing model will work when investors are forced to look at component stock fundamentals rather than their momentum. The miracle of indexing may join Milliken junk bonds and Big Recession mortgage derivatives as just another set of Wall Street products gone awry? (Thanks to Adam Zybko for statistical analysis).

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Rob McCreary

Rob McCreary has more than 40 years of transactional experience as an attorney, investment banker and private equity fund manager, and has spent his career in building entrepreneurial organizations with successful track records Founder and chairman of CapitalWorks, he is responsible for developing and maintaining senior relationships with investors and portfolio governance.

This blog represents the views of Rob McCreary and do not reflect those of CapitalWorks or its employees. This blog is not intended as investment advice. Any discussion of a specific security is for illustrative purposes only and should not be relied upon as indicative of such security’s current or future value. Readers should consult with their own financial advisors before making an investment decision.

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