the Jerk

A simple lure: 'you don't have to do much work to find good investments.' While plainly false, the promise of easy money has drawn naive newcomers for decades.

Earlier in the year, United Airlines became entangled in a scandal that went viral. A passenger was dragged off a flight to make room for off-duty United crewmembers that needed to travel to their next assignment.

The worst part: there was video. Several passengers uploaded footage from multiple angles. As a result, crowds on social media expressed collective outrage and voiced their overall dismay with the their experience with airlines.

“Every day, we help unite the world by connecting people to the moments that matter most.” - post by United’s CEO, Oscar Munoz, on the company’s official blog¹

Unfortunately for United, a moment on Twitter united millions of people against the company. To make matters worse, United’s CEO initially defended the actions² before reversing his position³.

The scandal was discussed in news segments, late night shows, dramatic headlines like ‘Why United Airlines Would Rather Beat You than Pamper You’, and even spawned a satirical Brazilian ju-jitsu defense.

News articles were quick to forecast dire times for United Airlines’ parent company, United Continental Holdings. The company was set to open 4% lower based on pre-market trading the following day. Twitter spoke, the market heard, and all seemed obvious.

Despite this, United never really slipped. There was a slight, 1% drop within a few days, but the stock never took a major hit. Headlines hyped up the downfall of United, pointing to an ephemeral change in market capitalization as support for a lasting judgment. More than 3.5 million tweets were sent with the hashtag #BoycottUnited. They even posted a 5% increase in domestic passenger count and higher earnings in their 2017 second quarter filing. The outrage seemed real, the scandal certainly was, but why didn’t it translate? What happened? What didn’t happen?

the Jerk

Steve Martin in the Jerk - a film about a bumbling, well-intentioned fool.

That was the Jerk. The knee-jerk, sudden reaction driven by short-term sentiment rather than analysis. The Jerk is like a bumbling, unwanted house guest. It arrives, largely uninvited, and you’re never sure how long it will stay. It’s the helpful friend that has a common-sense explanation for why you should take action. In this case: United angered a lot of people, a lot of tweets said they wouldn’t fly United, so United should have fewer customers and lower profit. Simple. Easy as pie. Unfortunately, simple and easy, but by no means certain.

Value investing requires research. An investment thesis might begin with a quick observation, but it has to be followed up with an understanding of the company’s operations, their financial situation, and future prospects in order to move towards analysis and away from speculation.

The Jerk presents a flawed, myopic shortcut for analysis. Rather than assessing each situation’s unique context, it simplifies the world into a single maxim: buy on good sentiment, sell on negative sentiment. But investing isn’t a simple, one-step game. There’s a more encompassing, a second order game in which you have to make a prediction with awareness of other predictions. For instance, a company hit with a $50M fine is obviously negative, but if the market consensus expected a $500M fine, then the outcome is relatively positive. This is the basis of distressed equity and strategies which aim to identify over-reactions.

How can investors identify these over-reactions? How can you spot situations that will likely translate to lasting earnings impact rather than just a blip in the news cycle? Here’s a framework to help cut through scandals and avoid having your portfolio fall victim to the Jerk.

The Framework

Four key factors seem to impact these situations:

1. LEGALITY - Is it illegal or just unpopular?
2. AGENCY - Was it an accident or did it occur by design?
3. SCOPE - Was it system-wide or just a one-off freak occurrence?
4. SCANDALASTICITY - Do customers have substitutes or is the outrage impotent?

Legality

The first major distinction divides scandals into two distinct groups - the ones that break laws and the ones that only break social norms. The worst scandals are loud and noisey, owing to the torches and pitchforks of popular outrage, while also precarious due to the force of looming governmental action.

Illegal - Against the Law. The worst scandals create legal risk. Generally, company management has been lured by something highly profitable, but unfortunately illegal. In these situations, regulatory intervention leads to prohibitions and ultimately lower profits. Further, they may result in fines which, while nonrecurring, can represent significant and direct value loss.

Unpopular - Breaking Norms. Scandals can be hard to judge when they don’t involve breaking a specific law. In the case that they aren’t violating the letter of the law, but are deemed to violate the spirit of law, the risk of governmental action still remains. This could include activities where legality relies on intent, such as tax evasion or anti-competitive practices. Regardless of the outcome, they often lead to regulatory investigations, legal fees, and bad press.

In other cases, the action is simply unpopular, but fully within the legal right of the company. These tend to be policies that expose the company’s profit-seeking at the expense of the customer, the environment, or the political process. It might be a company that has consumer-hostile practices, pollutes the environment, or influences government through lobbies and donations⁴. The popular frustration without legal recourse leads activists to seek new laws and draw attention through boycotts and petitions.

Agency: Was it intentional or accidental?

Scandals that arise from intentional plans or policies are much more alarming. Nothing angers the mobs that meet on Twitter and Capitol Hill more than an unethical businessman. It plays perfectly into themes of corruption, earnings over ethics, and conspiracy.

They represent a greater potential for regulatory/legal action, since they demonstrate agency and premeditation. Agency allows for the laying of blame and assigning of responsibility that facilitates further legal action. Even worse, if management acts unethically in one domain, it casts suspicion on all management decisions.

Scope: How system-wide was it?

The more expansive the issue, the more indicative it might be of an intractible problem. Rare events and freak accidents are generally less worrying since they seem extraordinary and unlikely to affect happen again. An individual passenger getting dragged off a flight might be a one-off, but the E. coli scare that struck Chipotle in 2015 is something more likely impact a wide group of people. It’s easy for customers to think “that won’t happen to me” when a scandal is an isolated incident.

Scandalasticity

Yes. Scandalasticity; it’s new. Consider it the less popular cousin of price elasticity of demand⁵. The general idea is simple: in order for a scandal to have an impact, consumers must be willing to substitute. In order to substitute, they need other options. Without other options, consumers lack economic outlets to express their frustration with the company. Sure, they can complain online, but it will have minor effects on the company financially if their spending behavior is unchanged.

Returning to United, flights are extremely price elastic. This means consumers are highly motivated by price when they purchase airfare. As a result, they’re less likely to change behaviour due to scandal because they’re so focused on prices.

“It is difficult to get a man to acknowledge a scandal, when his finances depend upon his not acknowledging it!” a paraphrasing of Upton Sinclair

The highest scandalasticity situation would involve an easily replaceable purchase with low price variation. Imagine that you discover the local coffee shop uses child labor. How long would it take to find a new place for your espresso fix? Even if you had to pay 30% more, it wouldn’t likely be more than a dollar. Unless you’re a coffee enthusiast, coffee’s largely replaceable with insignificant price variation.

“a flyer is only loyal to its wallet” - unattributed quote

Fortunately for United (and unfortunately for upset customers), air travel doesn’t fit the bill. When it comes to airfare, consumers are highly price sensitive, often choosing flights more based on price than on brand loyalty. In addition, airlines are not always easily interchangeable. There may be some routes that are only serviced by specific airlines. The same person who tweeted “I’ll never fly United again” would quickly change their mind if their upcoming flight were 20% cheaper with United or if there weren’t other alternatives.

Illustrated frameworks for thinking about scandals.

Conclusion

The factors described above don’t focus on quantitative measurements. That’s not to say the numbers should be ignored, but more that unmeasurable factors shouldn’t be overlooked⁶. Value investing requires the synthesis of various quantitative and qualitative skills. It’s closer to being an investigator than a mathematician. Exploring each factor will lead to more questions and require further analysis. You’ll learn about a wide range of industries, read legal documents and make financial projections.

Do the Work

There’s no sidestepping the need to read through the filings. The perspective of popular outrage on social media or general news media is completely different than that of a value investor. Journalists often draw on scandals to make a point about larger societal phenomena or, at worst, to stir up emotion with sensational, opportunistic interpretations. The disconnect comes from mistaking persuasive or sensational articles written for a general audience with objective, critical analysis useful for financial decision-making.

It’s important to understand how the company makes their money in order to gauge the potential impact from the scandal. Is the scandal limited to a geographic region? If so, check the portion of revenue comes from that region. Does the scandal involve a specific product line? Read through the filing to identify how much revenue comes from the product segment, then estimate what revenue might be if that product line was cut in half or completely eliminated. It’s important to understand what portion of the business is impacted since the scandal might touch a relatively small portion of earnings, yet have an outsized impact on the stock.

Don’t Fall for the Jerk

Most companies that can garner major news attention and outrage are multi-billion dollar firms that likely aren’t the best candidates for small value investors. United caught this much attention in the media because so many people fly via United. This being the case, they’re a multi-billion dollar company with many hedge funds and analysts closely following them. These situations are likely to be widely acknowledged early on.

The Jerk offers a simple lure: you don’t have to do much work to find good investments. This is plainly false, but for decades, and more decades to come, the promise of easy money has drawn naive newcomers and perpetual pawns. If your idea of investing is indistinguishable from picking a lucky number on a roulette wheel, then there’s pain up ahead. With such a gambler’s mindset⁷, trading floors lose to casinos every time – both will lose you money, but at least casinos offer liquor or lights.

Ultimately, value investing is hard work. The work shifts the activity from picking stocks like they were lucky numbers to developing theories about the future using available information and analytic prediction. It requires a subtle mix of numerical skill, critical thinking, and reflection. To succeed, you’ll have to do primary work rather than piggybacking on someone else’s idea or letting the common sensical simplicity of the Jerk sway you. You can always find a shortcut to bad decision-making, but good investment decisions require work and analysis.

Apollo, echoapollo.com, makes analyzing corporate filings more efficient and less painful. Change Detection cuts down the time spent identifying new developments. Fact Detection intelligently highlights important events.

1. A post on United’s corporate blog ↩

2. United CEO’s initial internal email on scandal ↩

3. United’s CEO apologizes for the scandal ↩

4. Let me know if you have any examples of a company that fulfills all three (consumer-hostile, environment-polluting, and highly politcally active) by email or @echoapollo on Twitter. ↩

5. “Price Elasticity of Demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price, [all else being equal].” ↩

6. The McNamara Fallacy fits this pretty well. It essentially describes having an overly quantitative model of a situation with significant qualitative factors. ↩

7. I mean the average speculative, “I feel lucky” gambler, not the calculating, strategic advantage players like Phil Ivey. ↩