Project #4209: Bear Stearns

Barry Ritholtz penned a post last week asking how an investor/trader would approach the purchase of Bear Stearns (BSC) stock at $30/share, days before it would be sold to JPMorgan Chase (JPM) for $2/share (eventually the bid was up to $10/share). It took 4,209 days for this trade/investment to reach break-even.

When investing, an individual will be wrong many times. If that individual is lucky enough, she will have the opportunity to learn from these mistakes and apply those lessons to future investments. Like most situations in investing, the analysis of the BSC trade will require looking at multiple scenarios and assumptions around the basis of the trade/investment. I will begin first by looking at the decision as a trade.

If the broker making the trade is looking at the Bear Sterns price chart, seeing that the stock price has fallen over 50% in three months while the S&P 500 has only fallen 10% is intriguing. It could be easy to justify the trade by acknowledging that Mr. Market is simply having one of his manic-depressive moments with BSC. Just two days before, the BSC CEO went on CNBC to tell viewers that the firm was fine. If that is the nonchalant attitude the broker is taking with this trade, I hope that the amount of capital used for the trade is trivial in relation to his overall portfolio. If that is the case then there is nothing to learn here. It is nothing more than a spin of a roulette wheel. But if a material amount of capital were used for the trade, then the individual is a reckless gambler and should remove himself from all future investing activities.

The BSC trade took place on Friday and JPM announced it was acquiring BSC on Monday. Whatever the original thesis was for the trade, it is no longer valid. The trade should immediately be sold for a loss, as painful as it is. The next step would be for the broker to examine if there is an attractive trade opportunity around JPM. The exception would be that due to the chaos surrounding the acquisition, it wouldn’t be irresponsible for a broker to wait for a higher bid from a competing bank or JPM to satisfy BSC shareholders.

BSC as an investment

The ex post analysis of an investment made in BSC will be done as an examination of how I would pursue a potential investment. This would begin with an analysis of my edge. Michael Mauboussin has written about the four types of edges that are available to an investor, behavioral, analytical, informational, and technical (BAIT). An informational edge on BSC is most likely not available to an investor, unless she works for the New York Federal Reserve, in which case an investment would be illegal and unlikely given the true liquidity of BSC. An example of a legal analytical edge is the work done by Michael Burry in The Big Short. The technical edge is also unlikely since few sellers in the market were selling because of BSC credit rating downgrade on March 14 from A2 to Baa1as it was still rated investment grade. Also, while BSC did report a quarterly loss on 12/20/07, that alone would not cause a significant amount of technical selling over the next 3 months. This leaves us with an analytical edge and a behavior edge.

Analytical Edge

There are five ways to exploit an analytical edge

1) More analytical skill

2) Weighing information differently

3) Updating views more effectively

4) Operating on a different time scale and

5) Anticipating a change in the market’s narrative.

If an investor truly had better than average institutional analytical skill, an investment in BSC is like not made (see Burry, Michael). This skill also transfers over to “weighing information differently” and “updating view more effectively.” If an investor is operating on a different time scale, three to five years, under the belief that BSC is not a going concern (btw not mentioned in their last 10-K issued on 01/29/08, seems appalling in hindsight), than $30 would seem to be an attractive valuation. The final analytical edge to exploit is narrative change, which could be used as an investment justification.The power of storyis understanding how the market’s narrative will change, leading to a revision in price.

At the end of the day, the value of a company’s stock is the cash it distributes to its shareholders over the company’s life. But a company’s stock price along the way can contribute to the company’s reputation, capacity to raise capital, and ability to pay employees with equity.” – Michael Mauboussin

Behavioral Edge

The behavior edge is based around understanding the difference between the “wisdom of crowds” and the “madness of crowds”. The wisdom of crowds requires diversity of opinion among market participants. Wisdom flips to madness when diversity of opinion is removed. The tech bubble of 1999 of a good example of the madness of crowds while the current bull market is a good example of the wisdom of crowds. Even at $30, it could be argued that there was still strong diversity of opinion around BSC given that the average target price was $93.

Overextrapolation is a behavioral exploit that could be used to justify an investment in BSC. Overextrapolationis the excess projection of recent results into the future. Stock prices tend to be more volatile than the underlying fundamentals of a business (BSC is one of the few examples where the stock price was less volatile than the company’s fundamentals). Overextrapolation leads to higher/lower valuations, which in turn result in lower/higher future returns. In order to avoid overextrapolation, it is best to follow Seth Klarman’s definition of value investing,

“Value investing is at its core the marriage of a contrarian streak and a calculator.”

The contrarian view requires the investor to examine the popular view in the market, and the calculator requires an investor confirm the valuation is sufficiently extreme to generate excess returns (I hope the investor in BSC got a new calculator on 3/16/08).

The Value of a Checklist and Decision Journal

The volatility of BSC stock price is a reminder why check lists are so important for investors. The dramatic swings in price, endless commentary, and uncertainty surrounding the company can cause even the most stoic investor to become emotional and act irrationally. Michael Mauboussin wrote about Managing the Man Overboard Moment as a guide for investors when a stock drops 10% or more in a single trading day. Part of the analysis includes going through a checklist to determine how to help determine if this is an event that should cause the investor to rethink their investment or if it is a manic-depressive moment for Mr. Market.

But the checklist should also be used before an investment is made. There is a wonderful interview with a few investors about the importance a checklist in their investment process. It forces you to analyze all the issues surrounding a stock. One quote that stood out to me was about leverage and access to capital:

“The other element on the leverage side that has come up for me since the 2008 crisis, it’s stopped me and I can’t give you specific examples, but the leverage doesn’t just extend to balance sheet items. There could be elements of revenues that depend on the customer being leveraged and if the customer can’t access the capital markets, it will hit your revenues in the same way” – Guy Spier

Unless you are Buffett or Munger, it’s very difficult to keep all the assumptions and variables surrounding an investment straight in your head. A checklist formalizes the process.

A checklist works especially well when pair with a decision journal. The decision journal helps prevent hindsight bias when examining the outcome of a decision.

The collapse of Bear Stearns is a good reminder to examine your process as an investor and understand if a bad outcome was the result of bad luck or a poor decision.

The views expressed are my own. They have not been reviewed or approved by my employer. Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. Please read my disclosure page.

To share: