The Allure of the Equity Stub

Consider this hypothetical example:  The shares of a high-flying company falls 50%.  You’ve heard of Mr. Market’s mood swings so you purchase the shares seeing the price dislocation as a terrific buying opportunity.

Anchoring

While you believe you're making a contrarian bet, you may have fallen victim to a behavioral bias:   Anchoring (on a recent higher price like the 52-week high).  

Value investors in challenged sectors like commodities, industrials and certain technology sectors, who are slow to re-calibrate their internal risk/reward models, may be more susceptible to this bias. 

The Capital Structure

When a stock falls sharply, pay heed to the business’s capital structure – the debt and equity.  The equity of a company, with tons of debt, could experience large swings for even small changes in the business’s enterprise value.

Leverage math

Say you purchase a home with a 20% down-payment.   If the home price rises by 10% your equity in the home is up 50%.  If the price falls 10%, your equity is down 50%.  If the price falls 20%, your equity is wiped out.  Equity investors sometimes forget this basic principle. 

For more on behavioral biases in investing please refer to these prior posts:

 

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