Four Reasons Why A Stock is Hated

Updated: 6 days ago



Joel Greenblatt has one of the best track records of all professional money managers. He wrote several books on investing but two of those — You can Be a Stock Market Genius and The Little Book That Beats the Market — are widely read on Wall Street and have influenced an incredibly large number of investors ranging from retail investors to hedge fund managers.


What you may not know is that there is an even bigger gem out there of Joel Greenblatt’s teachings than those 2 books that is available for free.


A student in one of Joel Greenblatt’s MBA classes took very detailed and well written notes from 2002–2006 that he shared. I don’t have his full name but he left his email address on the notes so hat tip to aldrige56@aol.com for the incredible notes which I posted a link to download at the end of this post.


I’ve read through a lot of these notes but there is one class that got me thinking today and that is the class where Brian Gains of Springhouse Capital gives a guest lecture on dying industries and hated stocks.


Brian mentions that there are four reasons why a business is hated which results in its stock price being hated.


Those 4 reasons are:


1. The business is unsustainable

2. The business has a bad balance sheet

3. The business is cyclical

4. The business is dying


Unsustainable Business — An unsustainable business is a business such as Moviepass (Helios and Matheson Analytics) or etoys.com. These businesses operate at too much of a loss and they are not able to raise enough capital to fund the losses and keep the business afloat so they eventually have to file bankruptcy.


Sometimes it’s an outright flawed business model and sometimes the business model is too ahead of its time but either way they aren’t sustainable because they can’t sell their product or service at a price that exceeds their costs for a long enough time period to become cash flow positive so their lenders and investors eventually give up providing capital to the business to keep it alive.


Bad Balance Sheet — A strong balance sheet is what makes a business resilient during tough economic times because they can withstand a period of losses and lost revenue.

A weak balance sheet makes a company fragile during tough economic times because their debt obligations could come due during this period and the company may not have enough cash on hand or enough cash flow from operations to survive.


And if a company can’t meet its debt obligations or it can’t refinance then it will have to file for bankruptcy and the equity holders will be wiped out. Investors will then pay less for the stock due to this risk of losing their investment.


A weak balance sheet also results in less cash flow leftover for equity holders since they have to pay interest and use cash flow to pay off the debt holders who are above them in the capital structure. An example of this is Kraft Heinz* during the coronavirus pandemic.


Despite a time where Kraft Heinz products are seeing more demand due to stay-at-home orders from the government and more people shopping at grocery stores instead of going out to eat at restaurants, Kraft Heinz’s stock price has languished due to its bad balance sheet.


Cyclical — Earnings and free cash flow are what drive a company’s stock price over the long term and companies trade on a multiple to these earnings. The lower the earnings, usually the lower the stock price.


And less earnings mean less cash flow and that can make the business more exposed to the downsides of an economic recession. If a company isn’t earning any money or cash flow at the present time but investors think the company will earn money sometime in the future then they may bid up the price of the stock which is similar to what is happening to Tesla right now.


But if the company is mature and is cyclical like a steel producer, a bank or an oil company then a recession will lead to consumers cutting their spending resulting in lower sales.


These lower sales will then result in much lower earnings and free cash flow depending on how sensitive and exposed the company is to the economy at the time. These lower earnings and free cash flow will drive the stock price down.


There are a lot of cyclical companies today that have seen their stock prices fall due to lower sales resulting from the current recession that was brought on by the coronavirus. A lot of those companies belong to the following industries: casinos, banks, airlines, car manufacturers, oil companies and hotels.


Dying Businesses — Dying businesses, also known as “melting ice cubes”, will see their stock hated by the market because the value of stocks is driven by the discounted value of the company’s future earnings and even if today’s earnings are high, if the market thinks that earnings in the future will be lower then that will result in a lower stock price today as these lower estimated earnings are discounted back to today.


An example of a melting ice cube that just experienced the coronavirus speed up its destiny was J.C. Penny who just filed for bankruptcy after struggling for at least a decade as the business quickly lost value but slowly experienced the inevitability of bankruptcy.


Another dying business is coal since coal is the biggest emitter of carbon dioxide out of all of the fossil fuels and the world has started to act on preventing more global warming from occurring.


Link to Joel Greenblatt’s Columbia MBA 2002–2006 Class Notes: https://www.mikegorlon.com/downloads


*Disclosure: I own shares of Kraft Heinz at the time of writing.

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