Hertz’s Stock Rebound
And what it says about American investors today
|Written by Tom Yeung, CFA | CDFA|
Investment Advisor & Fund Manager, Jurnex Financial Advisors
As stock markets reach new post-pandemic highs, a curious case of FOMO has set in. Behavioral economists often quip: what’s the only worse feeling than losing money in the stock market? Losing money in the stock market WHILE seeing your neighbor get rich from it.
Retail investors have piled into the stock market following the COVID-19 market declines. Fidelity saw a record 1.2 million accounts opened in the first part of 2020, and the stock market saw a near-40% rise from its March 23rd nadir.
No doubt, we should partially attribute the bounce to the improving COVID-19 outlook. The virus is indeed deadly, but not as fatal as first believed. Over the past month, researchers from the WHO and Imperial College concluded that COVID-19 kills roughly 0.66% of carriers, rather than 2.5%.
Predictably, the overall stock market reacted with morbid glee. March’s stock market priced in an impending viral disaster, while today’s market prices in sunny skies.
We know that stock markets should only care about future earnings. Whether its an economic crisis or boom, a rising pandemic, or a fading one, the market only “cares” about its impact on potential company earnings. It sounds shockingly heartless – it’s as if the market gets up every day only to ask itself: will enough Americans be alive after COVID-19 to go shopping today?
But stock values are based on future earnings, not compassion. In words from the movie The Godfather, “it’s not personal – it’s strictly business.” Stock markets are simply incorporating new information on an instantaneous basis.
The Rise of Junk Bonds
Yet, something is rotten in the state of investing. Highly leveraged, low-performing companies, such as Norweigan Cruise Lines and Apache, have significantly outperformed their better-capitalized peers. Investors have collectively thrown caution into the wind, concluding that the US government can (and will) do “whatever it takes” to backstop the US economy.
Nowhere is this more apparent than in the junk bond market; since the stock market’s low on March 23rd, the aptly named JNK (SPDR Junk-Bond) Index has returned 22.8%. The investment-grade SPDR FLRN has returned just 8.9%. Today, junk bonds are down just 5.1% since the beginning of the year.
Professional investors have been busy voicing their concerns. Earlier this month, top investor Leon Cooperman put it bluntly about mom-and-pop investors. “They are just doing stupid things,” he said on a CNBC interview, adding, “let them buy and trade. From my experience, this kind of stuff will end in tears.”
And yet, these words of warning haven’t stopped retail investors from diving in headfirst.
Investing in Zombie Companies
On May 24th, Hertz declared bankruptcy. The COVID-19 crisis had all but eliminated its underlying business, and the company’s highly leveraged balance sheet (due to a prior private-equity buyout) meant that its annual interest bill was all but unpayable.
Japanese investors typically call firms like Hertz “Zombie Companies.” These are companies that earn barely enough to repay interest on their loans but don’t earn enough to pay back the principal.
Imagine a family struggling with credit card debt. They might have earned a lot in the past, but these days, they’re not as well-off. Perhaps their local economy took a turn for the worst. Or their skills aren’t as in-demand. Whatever the case, the family can now only afford to pay the interest on their credit card bill. So no matter how hard they try to save, they find themselves unable to pay down the principal amount of credit card debt they owe. It’s a cycle that millions of Americans increasingly find themselves in.
While Hertz isn’t a credit card borrower per se, the company now finds itself in a similar situation. The company carries a 4.7% interest rate across its vehicle and non-vehicle debt, a relatively standard rate in the industry for its B3 bond rating prior to bankruptcy. However, with an astonishing $17.1 billion in debt, Hertz’s interest payments come to a staggering $800 million per year.
Even in good times, the interest bill was barely payable. In 2019, the company earned just $649 million adjusted EBITDA, a beautified cash flow measure that ignores reinvestment into the business. One does not need a finance degree to realize that $649 million of phantom earnings doesn’t cover $800 million of interest payments.
And in truth, the reality is far worse. As Warren Buffet once quipped, “Does management think the tooth fairy pays for capital expenditures?” Using more stringent cash-flow measures, investors will quickly realize that Hertz requires $1.5 billion of capital injection EVERY year.
Doctor, Will This Hertz?
Unsurprisingly, the COVID-19 crisis became the final straw that broke the camel’s back. Years of debt accumulation finally caught up to the company.
Most observers would have shrugged their shoulders at Carl Ichan’s $1.6 billion loss from the now-bankrupt company. After all, big investments in highly indebted firms come with significant risks.
Even the company published a blunt memo to shareholders after the bankruptcy, stating, “we expect that common stock holders would not receive a recovery through any plan unless…a significant and rapid and currently unanticipated improvement in business conditions to pre-COVID-19 or close to pre-COVID-19 levels.”
And yet we have a stock that, instead of dropping to zero, soars from $0.56 to $5.53; who’s price seems so intriguing that 170,000 investors on Robinhood bought the stock without hesitation. It’s as if people, longing for the casinos of Las Vegas to reopen, found their fix from day-trading instead.
Professional investors like Leon Cooperman tut-tutted the investment as “speculation.” In truth, the same fund managers might have wished they’d taken part in the madness.
Hedge fund manager Stanely Druckenmiller told CNBC, “When COVID hit, I was pretty much of the view that there was a good chance that the credit bubble had finally burst and the unwinding of that leverage would take years.” Since then, he admitted being “humbled” by the market; his fund is up just 3% in the market’s 40% rally.
Stocks And Sports Gambling
Imagine a football team that’s lost five games in a row. A sports gambler, seeing long odds for the sixth game, might put down a wager on the losing team. After all, he might wonder: what are the chances a bad team loses more than five times in a row?
But imagine the team loses AGAIN. That’s what happened the day Hertz declared bankruptcy, shedding another 24% between Ichan’s stock sales and inter-day close.
You would think investors would learn lessons from blindly backing losing teams. But the stock market isn’t a forgiving teacher. That’s because institutional memory gets quickly forgotten as old investors drop out, and new investors rush in.
So imagine the following weekend. The football team now has SIX straight losses. Then, a NEW gambler then walks into the sports bar. Feeling lucky, the fresh soul puts a wager on the same losing team; he has no memory of the first gambler’s loss. And the odds are so long that the second gambler feels he has nothing to lose.
And that seventh weekend, a miracle happens. By some stroke of luck, the losing football team WINS. And now the second gambler feels like a genius.
The Pavlovian Cycle
The stock market often turns into Pavlovian cycle that rewards outcomes rather than the initial action. It’s much like lottery winners who convince themselves that they’re more skilled in picking winning Powerball numbers. But even though they realized a great outcome, it doesn’t mean that using fortune cookie numbers is any better than using your kid’s birthdays to win lotteries.
So what are some winning strategies? There are reasons a professional gambler MIGHT have bet on the weaker team in week 7: injuries on the opposing team, a home-field advantage, or an offensive lineup that’s particularly well-suited against the superior team’s defense. Even more simply, the bookmaker’s odds might have been overly pessimistic about the losing team’s chances.
The average investor, alas, often doesn’t weigh these considerations. Few investors create decision-trees to assess the possible value of Hertz’s common stock to remaindermen shareholders. They aren’t checking the subordination schedules of the company’s debts, or the free cash flow available to the firm. Who has time for that?
Are The Professionals Wrong?
Could Hertz shareholders survive? Possibly. American Airline’s 2012 de-listing and subsequent recapitalization by US Airlines gave shareholders of it’s near-worthless OTC stock (valued at just $0.07) over a 1,000% return in just three short weeks.
And let’s not forget that high stock prices can cause even higher stock prices. As George Soros explained, the theory of reflexivity means stock prices can influence underlying values. “Distorted views can influence the situation to which they relate because false views lead to inappropriate actions,” he said in a CEU lecture.
Put another way, a company with a high stock value like Tesla would find it easier to build on past success. Want to hire top talent? Pay your star employees in stock grants. Need to build a new factory? Issue new shares with minimal dilution to existing shareholders. While a high share price can initially seem like a house of cards, a competent management team can use the scaffolding to build a solid foundation underneath.
Can Hertz pull off what Tesla did? Highly unlikely. The company needs to raise between $1.0-1.75 billion this year just to remain solvent, depending on how lenient its creditors feel. And what about shedding its “Zombie Company” status? Hertz’s new CEO, Paul Stone, would have to drum up $4-6 billion in new funding. Hertz’s now-canceled $500 million share issuance would be a drop in the proverbial bucket.
How To Invest From Here
Regardless of the market situation, investors need a healthy respect for three things.
First, are the company’s real-world prospects reasonable? Can the business thrive in the near-term and long-term? Second, does the company have a viable financial structure? Even well-run companies can become undone by lousy or highly-leveraged balance sheets. Third, how does the current market price reflect these fundamentals? Even the best companies in the world will have a finite market value.
Investors ignore any of these three principals at their own risk.
And what if they ignore all three? Then that’s like a gambler walking into a sports bar with his life savings, saying, “well, it looks like the Browns have lost again… but they can’t possibly lose EIGHT times in a row, can they?”
Where to find more resources
If this seems like a lot of information, don’t worry. The great news is that help is available. That’s because here at Jurnex, we work with individuals and families just like you to make the most out of investing. I’ve helped invest client money for over a decade in the same old-fashioned way. And that’s to seek out great companies in great industries that can you can buy at a discount to their fair value. Sounds too simple to be true? Give me a call today, and I’ll show you that it’s still possible after all these years.
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