Thursday, May 29, 2008

Waiting for a ride on the Phoenix

As a follow up to my previous post on Altman Z score, investors who use solvency analysis to avoid bankrupt companies should beware of the effects of an economic recovery. The other side of the coin of solvency analysis is the Phoenix effect.

When the economy comes out of recession, shares of near-bankrupt companies see eye-popping returns as they rise Phoenix-like from the ashes of near insolvency. Examples include Chrysler moving from $2 to over $30 in the 1982-3 recovery; Magna International from under $2 to over $80 in 1991-2; and Akamai Technologies from under $2 to over $18 in 2003-4.

Buying shares of near bankrupt companies is a dangerous but exciting game. To be successful, an investor needs to identify the Phoenix candidates and correctly time the turn in the market. The rewards are can be big. Buying a basket Phoenix stocks can yield returns of 100-200% over a 12-18 month period.

Phoenix is partly a small cap effect
The Phoenix effect can be characterized partly as a small cap effect. The chart below shows the relative returns of the small cap Russell 1000 relative to the large cap S&P 500. I indexed the start value of 100, at dates representing stock market lows coinciding with economic slowdowns since 1980. On average, the Russell 1000 outperformed the S&P 500 by about 17% one year after the market low. The initial upward thrust in the market has always been marked by large cap outperformance.

Interestingly, the recent March 2008 low was characterized by small cap outperformance which leads me to conclude that this rally is just a bear market rally and the March low was probably not THE BOTTOM in this bear.

Looking for Phoenix candidates
Phoenix candidates are not just small cap stocks, but shares of companies that are at risk of insolvency and benefit from the tremendous positive operating leverage from an improving economy and high financial leverage which put them at risk of bankruptcy. The obvious quantitative way of finding Phoenix candidates is to screen the market for shares of companies that are at risk of insolvency. However, there is a simpler heuristic: low-priced stocks.

Stock price is a factor that’s not in most equity quants’ factor lists. However, it is a deceptively simple way of screening for Phoenix recovery candidates. I remember that Jeff deGraaf, who was at Lehman Brothers at the time, reported in late 2003 that the return spread between the lowest and highest decile of stock price was about 70% - an astounding return to a factor for less than one year.

I roughly confirmed these results by running a backtest using the current components of the Russell 1000. Had you bought the lowest decile by stock price in December 2002 and held them for a year, the median outperformance compared to the top decile was about 110%. This simple study has problems, mainly in the form of a survivorship bias. The use of a median return instead of an average return does mitigate some of the survivorship bias issues. Nevertheless, it does illustrate the magnitude of the effect. Using a long-only approach, this study over the 2003 and previous recovery period suggest that a basket of Phoenix stocks has the potential to rise by a factor of between 2 and 3 over a 12-18 month period.

Phoenix candidate = low stock price + dramatic fall + insider activity
Just buying low priced stocks gets you partly there but we should eliminate stocks that have always traded at low prices. Phoenix candidates are stocks that have taken a pounding, or stocks that have fallen dramatically (70-90%) from the 52-week high. This is a likely indication that it is at risk of insolvency.

These companies are on the verge of Chapter 11 so buying their shares is highly risky. To mitigate downside risk of possible bankruptcy, add an additional insider activity screen. Ideally I would like to see recent insider buying in Phoenix candidates, which indicates that the fundamentals may be turning. At the very least, I would like to see the lack of insider selling, a sign that the worst is may over for the company under consideration.

Timing: Be patient, the Phoenix will rise
Right now, the weight of the evidence suggests that the turn has not occurred yet. I am preparing a list of Phoenix candidates for my portfolio but waiting for signals of a bottom before buying. In a future post I will write about how I would time the buy decision of these stocks.


Henry Bee said...

Mr Hui,

That's a tremendous observation of the small cap effect. I never noticed the initial underperformance! Given that we've been in a bear market rally, do you think the S&P 500 will make a new low when the bear market resumes?

Henry Bee
Vancouver, Canada

Cam Hui, CFA said...


I don't have any models or indicators that show whether the market is likely to make a new low or not.

All we can do is wait for new developments and for the tape to give us a clue of what would happen. For example, the market will likely come back down to test the old low - I would like to see how it behaves at that point.


zenalgorithm said...

Please list your Phoenix picks now so that I can buy them before you and many others do.


Ricard said...

I don't think you even need to take the risk of speculating on potentially insolvent companies.

Look at CCI during 2002-2004. This stock posted a 3000% return from its low, even though it had a positive cash flow, and a book value of 0.2 at its low. Hardly insolvent.

Ricard said...

Correction, I was shooting from the hip on my last comment - Price to book, not book of 0.2 - CCI went from $1 to $45 over the course of 4 years, so I guess that's a 4500% return. Company has yet to make an actual profit during this time.

BTW, I'd also like to shamelessly pump a potential "Phoenix" stock that, again, is not even close to insolvent:

CIEN - telecom equipment maker.

This stock went through a reverse split not too long ago. It's flush with cash and just recently started making a substantial profit again. Split adjusted, it's trading at an all time low, and this is accounting for the dot-com bust, during which it was one of the more prominent poster childs that barely survived. It's down nearly 90% from the highs it reached last year. Debt to equity of 0.74, but here's the clincher - it has more cash than debt, to say nothing about the rest of its assets. Trading at half of current cash. Not quite Ben Graham, but probably about as close as you can get in techland.

I'd ride this stock into the mid 20s, where I may consider selling half my current stake. Or, if dreams come true, we ride a second tech wave induced by TV/internet convergence to even greater highs of stupidity before the second spotting of the black swan.

Happy hunting!

Trader Kevin said...

"The chart below shows the relative returns of the small cap Russell 1000 relative to the large cap S&P 500."

Please clarify. The Russell 1000 is not a small-cap index, but your chart is labeled as the S&P 500 against the Russell 2000, which is a small-cap index.