Recovery position - additional perspective

Schroder’s “The Value Perspective” wrote an interesting article in Jan 2014 entitled “Recovery position – Companies that have fallen heavily in value can go on to make big returns” (http://is.gd/doMrkE)

The notes that of the shares that lost 90% of their value, just 3% went bankrupt. About 40% of them lost money. 16% went on to 5-bag.

I have taken the values from their graph, and re-computed returns on a spreadsheet (http://is.gd/Onro8J). I have made an assumption that the high end of companies returns 500% returns is 2000%.

This raises a number of interesting observations. One is: can you improve your odds? My answer is: I can possibly give you three yesses and a no.

My first ‘yes’ is that you can probably improve your odds by reading RNSs, and eliminate those companies which say that value is unlikely to be attached to the company.

My second ‘yes’ takes the form that you should look for extreme cheapness, rather than just a 90% fall per see.

Before I get to my third ‘yes’, I want to give you my ‘no’: making money at this is a numbers game, not an intelligence game. Intelligence could well be counterproductive in this exercise. You have to go in with the attitude that you DON’T know what will happen, NOT that you have insight into the situation.

My third ‘yes’ is that you can probably improve your chances with highly-volatile shares. PREDICTABILITY is BAD. You want high uncertainty, not high certainty (insofar as you are not CERTAIN that the company will fail).

What you are doing is aiming for long-tail effects. Your median return is around -14.5% (i.e. negative), as shown in row 6 of the spreadsheet. But the mean return is 261%.

You need to place many bets, and get lucky, rather than place concentrated bets.

These conclusions are nothing new. If memory serves, Tweedy Browne wrote a paper on catching falling knives, and noted they obtained market-beating results. The above-average returns seemed to be from the longshots that paid off. So if you adopt the strategy, you should probably expect most of the shares to not work out.

In my observations above, I suggested using high-volatility shares. I suggest that as a proxy for the uncertainty surrounding the company’s prospects. I think that liquidity is also likely to work in your favour. One measure of volatility might be the company’s beta. I’m not sure I like that measure, as it measures share price movement correlated with the market. But that’s not quite the same as I’m suggesting. I don’t think high betas are going to provide an advantage per se. I’m just throwing ideas out here … you could of course actually take historical share prices and compute a normalised standard deviation. Failing that, if that was too much bother for you, then you might take the 52w high less 52 w low, divided by their average. That will give you a crude proxy for volatility.

Happy investing to you all.