Kick the tyres before you invest

The coronavirus pandemic, much like Black Monday in 1987 and the Global Financial Crisis in 2008, has presented a number of opportunities to buy stocks at seemingly “bargain” prices. But even if a stock seems like a steal, the infamous case of Hertz demonstrates the perils of investing for “fear of missing out” or FOMO without first doing your homework.

Hertz, America’s second-largest car rental company, was amongst the many victims of the pandemic, and on 22 May 2020 filed for bankruptcy. But then, in one of the biggest investment head-scratchers in a year already full of surprises, misguided day traders and retail investors suddenly started pouring money back into the stock.

From a company that typically saw a few million shares traded a day, an astonishing and logic-defying rise in demand led to a 533 million surge in trading volume, driving prices significantly higher. Having fallen from around $3 to just $0.55 in the wake of the bankruptcy announcement, this meant Hertz’ share price quickly rose again to $5.50 – an increase of 800%.

Looking to cash in on the frenzy, Hertz then decided to place an additional $1 billion of stock for sale. But even a back-of-the envelope valuation of Hertz showed the stock to be worth very little (and arguably worthless). At the time of the proposed share issue, revenue had fallen, earnings were expected to collapse, cashflow had turned deeply negative and there seemed little chance of revenue returning in the near future. To put things into perspective, the business was losing money for some time, and in 2019 alone spent $1.5 billion more than it made from renting out its cars. On this basis, we valued the company at -$14/share, making for a stock price worth $0.

Hertz itself highlighted in the investment prospectus (available on its own website) that these stocks would likely prove worthless, acknowledging that any investors would be essentially throwing their money away.

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Source: Cannon Asset Managers (2020)

This example exposes a key and all-too-common weakness in investor behaviour – the herd mentality. Hertz’ share offering sought to profit off inexperienced investors willing to buy the stock without first “kicking the tyres” or doing the necessary research – investors motivated by the fear of missing out on an opportunity rather than an objective view of the company’s investment case.

Breaking free from the herd

Without a sound investment strategy to guide their decision-making, many investors struggle to keep their emotions and biases in check. This usually means becoming overwhelmed by the temptation to jump on the bandwagon, buying stocks simply because everyone else is buying them, out of the irrational belief that a decision taken by a large group of people will likely be correct. Referring to the natural instinct of a flock of sheep, which walk closely together to avoid danger, this vulnerability is commonly known as herding behaviour. When an investor does not have a rational view on an investment, a common instinct is equally to simply follow the masses.

New investors are particularly susceptible to herding behaviour when it comes to so-called “hot stocks” or market darlings, often influenced by social pressures or the opinions of acquaintances, family, friends, and even the news. However, there is significant evidence to suggest that herding behaviour destroys returns.

Those Hertz investors who were late to the party and purchased shares at the $5.50 peak, for instance, would have lost a lot of money. The volatility of late May and June has since died down, and the share is currently trading at just over $1 again. Hertz is also just one example – there are plenty of similar cases of investors who lost money by flocking into stocks without doing any reading or understanding the risks involved.

The reality is that those investors who buy stocks at reasonable prices before companies become hot stocks or market darlings are usually the ones who profit – not the herders who rush in when prices are already high. Equally, investors who base their decisions on an informed understanding of the growth prospects of a company rather than a seemingly “cheap” stock are more likely to enjoy success.

Ultimately, the importance of financial literacy, and extensive reading and research cannot be overemphasised. At a high-level, before purchasing a stock, investors should first seek to answer:

  1. How does the company make money?
  2. What sector and industry does the company compete in?
  3. Will the company continue to make money well into the future?
  4. How strong is the company’s balance sheet?
  5. How much is the stock worth?

The moral of Hertz’ tale is that it is crucial to take the time to study and understand what you are buying with your hard-earned money, rather than making your investment decisions based on what others may be doing. There’s nothing wrong with tips and recommendations, as long as these act to feed your curiosity to do some further homework. Break free from the herd and seek professional advice for developing a sound investment strategy to guide your decision-making, rather than blindly following the direction of the masses.

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