I have written about the loss aversion of investors in the past and the tendency of investors to keep averaging the purchase price in the hope of breaking even in a stock.
While it can be justified in some instances, what is confounding is the tendency of investors to keep buying known bankrupt companies.
There was an airline. The airline stopped flying. The planes were all leased and not owned by the company. Salaries for the staff have not been paid for months. Airport charges, payments to caterers, lease charges, provident fund dues, taxes etc. are unpaid. Bank interest is overdue. Reported losses are more than the net-worth of the company. Landing slots and check-in counters, things of some value, are being allocated by the government to other airlines. What then is the worth of the company or the listed equity shares?
The above is a description of Kingfisher Airlines. Long after the airline had ceased operations, the stock continued to trade and found buyers. The airline shut operations in early 2012 and the stock continued to trade on the exchanges till the middle of 2015. The nominal price of the stock may be low. Say a few rupees “only” per share. However it is a certainty that the stock will be worth nothing. No matter how low a purchase price, in a bankrupt company, the loss will be 100 of the purchase price.
Kingfisher Airlines is not an isolated example from the past. Global Trust Bank shareholders likewise received nothing when the bank was taken over by the Oriental Bank of Commerce.
In the current scenario, where many companies are going into liquidation, the shares of those firms continue to find buyers. It is worth noting the difference between creditors and lenders to a company versus the equity shareholders.
Let’s say a company has operations funded by ₹ 50 of equity shareholders’ money and ₹ 50 of lenders’ money. Over the years, the company makes losses such that the accumulated losses amount to ₹ 60. In such a scenario, the funding received by the company from lenders continues to accrue interest and in fact grows over time. Finally, the company has to shut its operations and liquidate the assets. Sure, the assets will have some value; but in almost all cases, the realisation from the sale of those assets will not even be adequate to pay the lenders and operational creditors fully. In such a scenario, the equity shares of the company will be worth zero.
Running on the empty
Think of these shares as the equivalent of a movie ticket, which was for last week’s show or as a ₹ 500 or ₹ 1,000 currency note which has now been demonetized and no longer valid for exchange. These shares/ movie tickets/currency notes had value at some point in time in the past, but are worthless now except as collectors’ items.
Banks and financial companies are a special class when it comes to distressed companies. What makes these companies stand out is that the decline in such companies may appear to be sudden and out of nowhere. There are various reasons for this.
First, the reported financial statements deal only in aggregates and aggregates are opaque. The balance sheet only discloses the amount of lending done by the bank or the financial company and a detailed list of borrowers is not available. While these banks are audited and are subject to the supervision of the Reserve Bank of India, many a time, there is ample leeway available to the management to postpone the conveying of bad news on account of loan losses. Further, there are many exposures like bank guarantees that are called non-fund based exposures, which may suddenly materialise as actual liabilities in the future.
The second problem compounding the first problem of opaqueness is that the amount of borrowings by banks and finance companies relative to shareholders’ funds is very large. It is not uncommon to have shareholders’ funds of, say, ₹ 10 to enable borrowings of, say, ₹ 90. In such cases, even if a small portion of the loans given by the bank or the financial company goes bad, the firm may be in deep trouble and all of the shareholders’ funds may get wiped out in a short span of time.
Finally, the problem is the inherent nature of banking and finance. These companies depend on the continued trust of the investors. If the investors do not roll over their funding given to such companies or pull out funds, the companies may be in trouble.
Our mind is prone to making comparisons and of getting anchored to some numbers seen in the past. It is completely irrelevant as to what the high price of a stock was in the past. It is also completely irrelevant as to how low the price of the stock is today. A combination of the anchoring effect and loss aversion would explain why investors keep buying shares of bankrupt companies.
Investors would do well to stay away from fallen angels and avoid averaging the purchase price of a stock which the renowned investor Peter Lynch called as the “equivalent of watering the weeds.”