Betting on Zero
Malt Liquidity 80
X Marks the Bottom
As I alluded to in the last post, “stocks have… lost themselves, and “snapped back to reality”. The biggest growth names are all down 60%+ from their pandemic highs and aren’t likely to recoup their losses any time soon. However, a question remains — why haven’t some of these stocks zeroed out? Theoretically, shouldn’t all the stocks with overweight debt loads and no pathway to profitability zero out? Well… not exactly.
It’s surprisingly hard for a stock to actually go to zero. Speculators sometimes forget that, unlike crypto, which is primarily layered on top of hot air, there are actual underlying businesses represented by the tradable shares. We have talked about the equity vs debt split before:
Equity investments are based on prognostication — you think that the future forward earnings of the company will be markedly increased compared to its current day earnings, so you invest. Debt investments are loans — I gave you money to grow your business, so you better pay me back with what you earn over time. It’s the difference between giving your buddy $1k so he can drop-ship some fidget spinners to resell versus loaning your buddy $1k so he can pay his bail from the drunk tank to make work the next morning.
A very simple model for how businesses operate is they either sell a stake in itself to fund operations that gives a right to forward earnings — selling equity — or they borrow money to fund operations and pay back that money with interest in whatever way they can, usually through what they earn — accruing debt. As such, as long as a business has debt outstanding, they will do whatever they can to tread water as long as possible — when have you ever heard of a publicly traded company up and say “we have no path to profitability, so we’re going to liquidate everything and close up shop”? This would probably violate the fiduciary duty of any executive, whose goal is to bring value to shareholders. They will use every trick in the book to continue operations until they default, including restructuring, orphaning, technical defaults, and more.
Let’s look at an example in CVNA, the used-car vending machine company. The stock is down 95%, the used-car market lacks a pulse, and it’s pretty clear that this company is not going to be profitable anytime soon. Yet the equity still moves up as well as down, and it’s not going to zero anytime soon. What gives?
A cursory glance at CVNA’s debt tells the same tale. Notes issued in 2020 coming due in 2028 at a 5.875% coupon (which in itself is beyond hilarious that someone actually provided liquidity for this debt) are trading severely underwater:
However, this debt is due in 2028! (And they have more debt issued coming due in 2029 and 2030). While I make fun of the “everything is optionality” people, equity in stocks with severe debt issues shifts from trading in a normal delta one style — it doesn’t represent a stake in forward earnings, but rather it is closer to representing the probability that, when the company finally defaults and gets liquidated, shareholders recover some capital (remember that, ignoring complications like mezzanine debt and preferred shares, debt holders always get paid out before equity holders.) In effect, the shares have become a low delta call option on the company itself. Think about 5 delta SPY puts that we all know won’t ever go in the money — they don’t trade at zero. There is still extrinsic value. Shorting a stock like CVNA in the hope that it goes to zero essentially represents being short a call with an expiry that is years out, which is why short interest in stocks of companies that are clearly not going anywhere financially doesn’t max out, and why the Melvin Capitals of the world over-leverage themselves and get blown out trying to squeeze out the last drops of a stock down 95% already.
To be clear, while the probability is low that CVNA ever recovers and the equity resumes having actual fundamental value, this is not as bad of a trade as it seems! While the equity resembles an option, it is not an option — there isn’t “decay” in the traditional sense of holding an option, but rather the opportunity cost of capital that could be generating a return elsewhere. And sometimes these trades work out! Everyone made fun of retail for buying Hertz stock when it was bankrupt, but this trade paid off! Hertz recovered and made every smug pundit look like a moron. (Of course, retail gave these pundits far more scenarios that they were acting moronically a high degree of the time, but I digress.)
The larger point of this post is that this equity theory is part of why timing a bottom is so hard and why the adage “time in the market is better than timing the market” is so true. If you’re waiting for all the garbage to be flushed out, well, you’re going to be waiting a long time. Even when a company is in bankruptcy, like Revlon, the equity is still not zero! (Though it’s down 99.9%). Businesses that aren’t pure frauds like FTX don’t just disappear into the ether — even in bankruptcy, they can raise money to continue to operate.
I’ve never been a big proponent of fundamental analysis, but now that we are out of ZIRP, it is nice to be somewhat tethered to reality again, where markets don’t just move based on their proximity to Elon Musk.