Circumstances behind forced selling

Something to always keep in mind is that whenever you see a transaction, it represents a price that a buyer and seller agree to. When the price is lower than the previous trade, media and people alike state that “the stock has been sold off”, when more precisely it means that “the price that people are willing to sell it at is lower than those willing to purchase”. The number of shares outstanding after a trade is the same with the exception of a primary offering (a company offering shares directly to the public, which can also come in the form of option exercises or restricted share vesting) or a share buyback.

When can an investor get the lowest price? There are a couple circumstances that come to mind, both which are somewhat intertwined. One is that the sentiment for the underlying company is at a low – sometimes the reasons for this is legitimate (e.g. the business model went bust, such as what we are seeing in the marijuana sector at present), but sometimes the lowering of sentiment is transient – for instance when a poor two or three quarterly earnings results comes but the underlying business is still solid (yet stock traders cannot see the underlying strength). This happens all the time in investing, and one advantage of investors with smaller portfolios is that they can jump in and out of these circumstances.

The second circumstance where an investor will be able to capitalize on a low price is if there is forced selling, but these opportunities are transient. There are several situations where selling can be forced and I will outline them.

a) Index selling. For instance, if a stock is delisted from a major stock index, there will be a point in time where mechanical index funds will be forced to liquidate such stock, causing an increase in supply usually resulting in a lower price. Another variant of this is that the underlying ETF containing the stock is contracting its assets under management and the stock is required to be sold. This is one of the residual fears of passive investing – if ETFs are invested in financial products that are inherently illiquid, it will cause more price volatility. A nimble trader can take advantage of such downswings, although be forewarned there are many algorithmic traders looking exactly for these types of price dislocations – once you see it, it’s likely too late to act on it.

b) Fund policy required liquidations. For instance, if a bond fund is required to hold investment grade bonds, but a rating agency downgrades an issuer’s corporate debt into junk, the bond fund in question will be forced to liquidate the bonds, usually after some grace period to avoid a stampede to the exit. Another example are dividend funds that have a mandate that requires their funds to be invested in dividend-bearing securities – if a company decides to change its capital allocation strategy and cut dividends to zero, I usually wait a little bit before investing because there is usually a period of time where funds try to dump supply of such companies into the market. Another interesting variant we are starting to see is ESG-related divestitures, such as the divestment of fossil fuel companies in funds, or thermal coal divestment.

c) Margin liquidations. During significant market downturns, leverage forces leveraged funds to liquidate, which causes price decreases, which in turn requires them to liquidate more, etc. An extreme example of this were volatility ETF fund liquidations that occurred in February 2018 (thinking about the XIV ETF).

d) Required financing raises. This is where a company is floated on the market because the underlying entity requires capital. Two examples of this are Genworth MI (TSX: MIC) which was performed to raise money for Genworth Financial post-economic crisis, and AltaGas Canada (TSX: ACI) which I already wrote about being one of my worst misses that I did not take a stake in.

Ultimately if you want to capitalize on anything on the above, the supply pressure created by forced selling has to be in sufficient quantity and in a short enough timeframe to occur at a velocity that will create a low price. We saw a lot of this in the 2008-2009 timeframe, and more closer to present, in early 2016 and late 2018. When these forced liquidations occur, being on the opposite side of the trade at the right time can result in significantly excessive returns. As always, timing is important, and doing your research in advance and having a ballpark notion of valuation greatly assists in reducing the fear factor when you see a very ugly stock chart.

In particular, if a company has fundamental strength but is being subject to forced selling (which in itself could be caused by excessively negative sentiment), it can create highly profitable circumstances. Watch out for these situations.