Joseph A Hopper

Joseph A Hopper is Principal Consultant at the Theory of Constraints Institute (www.tocinstitute.org) and Executive Director at Sunstone Business School (www.sunstone.in). Prior to this, he headed Corporate Development at NIIT Ltd. where he oversaw the strategy, budgeting & review processes for 13 independent business units.

Catastrophe Investing: Profiting from Disasters

Joseph A Hopper

Catastrophe Investing Cover Web


On a chilly morning in mid-September, a news blurb made the rounds. It claimed that pollution levels from Volkswagen cars registered higher on the road than in laboratory emissions tests. At first glance, this seemed like just another run-of-the-mill recall incident. VW shares were down about 6%, not really enough to deserve a second glance.

Yet over the next couple of weeks, all hell broke loose. Shares (in this case the American Depository Receipt listed on the NYSE) fell 40% to settle around $23 (from $38, the day the EPA notice came out). At this price, VW was trading at fire sale prices! What a great opportunity to grab shares, an investor might wonder. But many questions remained; how much will the fine turn out to be? How will management defend their actions? They had accepted guilt, which seemed like a good sign. But could other brands and models also be affected? VW has about $35b in cash and sports marquee brands like Porsche, Audi, Lamborghini, Ducati, Maserati, SCANIA and others. Even in a worst-case scenario like liquidation, would the individual brands fetch more than this? Will customers ever forgive them? And given that VW is such a large employer in Germany with 600,000 odd employees, will the government go out of their way to support the company?

Could Volkswagen redeem itself?

Exploiting Companies in their Hour of Need?

It would be fiendish to view any crisis (whether natural or human-induced) with anything other than a deep sense of sadness and loss. But in the financial world, catastrophes are neither to be resented nor revered. They must be accepted exactly as they are.

 Once we cross this mental hurdle, we quickly begin discover that catastrophes often represent the best time to invest. The same forces that make it seem like ‘the ship is sinking’ are in fact what makes it so prudent to take bold bets.

 “The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.”

Warren Buffett, Chairman of Berkshire Hathaway

Recessions, tragedies, revolutions and the like result in immense loss of life, property and livelihood. Such extreme events bring about a sense of sadness in the air, muffling all sounds of laughter and silencing any views of optimism. You may have experienced this feeling when the World Trade Towers were brought down in 2001, when Southeast Asia was hit by a rogue tsunami in 2006, or when a powerful quake devastated Japan in 2012. While such events are taking place, it seemed like nothing will ever be the same again. And it won’t, especially for the ones who are directly affected.

 Post destruction, the human spirit yearns to resurrect, to rebuild. Some participate directly, by sending aid and relief. But it is not just the physical and human infrastructure that has been devastated. Financial institutions and markets, once solid and secure, lie badly shaken. Trust is nowhere to be found. Without a solid financial backbone, no broader economic recovery can ever take shape.

 One key way to participate in the effort of rebuilding is by purchasing the financial securities of the most-hit regions, sectors and companies. A show of solidarity not only contributes to overall stability but also signals support to others waiting on the sidelines. Investments at precisely the right time can turn the tide of sentiment and bring other participants back into the market just as support is needed.

“When written in Chinese, the word crisis is composed of two characters. One represents danger and the other represents opportunity.”

–   John F. Kennedy

Given enough critical votes of support, the markets and economy can indeed be resurrected. Most of the upside of this ‘future resurrection’ however, tends to get captured shortly thereafter. Take for example the Japan quake of 2011 and the World Trade Tower tragedy of 2001 (see graphs below). Almost all the loss in the respective index was recovered within one month of the disaster even though the actual recovery took many years:

Graph 1

Graph 2

According to efficient market theorists, this window of opportunity (however brief) should never exist. After all, markets like the Japanese Stock Exchange and New York Stock Exchange are broad and deep. They feature many participating investors and traders who are both knowledgeable and sharp enough to spot such opportunities.

 As per this well-established theory, financial markets tend to reward investors strictly based on their willingness to bear risk. If you wish to generate higher returns you must necessarily take on higher volatility. With this risk comes the likelihood of losses. If you are strong enough to withstand taking losses again and again, financial markets will eventually reward you with a commensurate increase in your overall portfolio’s return.

 In other words, systematically generating higher-than-average returns for a given level of risk should not actually be possible. Not only is the individual investor betting directly against the best brains in the industry, they are also pitted against comprehensive algorithms and artificial intelligence embedded into programs that trade securities based on selective triggers.

Hence, an investor must possess at least one advantage over others to earn higher returns in the market. But ordinary investors rarely ever enjoy an informational advantage (faster access to data that others), nor can they hope to compete against the sheer computational power of supercomputers running algorithms designed by PhDs. The common man simply doesn’t stand a chance.

But an individual investor can train herself to command a psychological edge. The emerging field of Behavioral Finance acknowledges that indeed, most investors are rational and therefore financial markets are efficient most of the time. But in extreme circumstances, investors tend to over-react. This gets amplified in catastrophes where fear spreads like contagion from one to the other, thereby creating opportunities to generate exceptional returns.

“Be fearful when others are greedy and greedy only when others are fearful.”

 – Warren Buffett, Chairman of Berkshire Hathaway

A similar tendency to over-react occurs in scandals and company-specific catastrophes. Some immediately come to mind such as Satyam (2009), Nestle (Maggi, 2015), Financial Technologies (NSEL scandal, 2013), Lehman Brothers (2008) and Enron (2001) in the US, British Petroleum (Oil Spill, 2010) in the UK, and Volkswagen (2015) in Germany, and many others in all parts of the world. Not every incident is an opportunity, but some surely were. Below is a table of stock returns for each of the above over various horizons.

Catastroph Investing Table

Note that 12-month returns for the survivors are far superior (on average) to ordinary market returns. Of course, this table also illustrates the level of short-term volatility that an individual investor must be prepared to stomach. A sceptical mind would tend to question why intelligent and savvy financial institutions are willing to wait in the wings, permitting individual investors to profit from such windows of opportunity.

Even though financial institutions and investment management outfits are driven by profit, they are ultimately run by people. In times of crisis, it can seem much more important to save one’s neck and not look bad, rather than dispassionately assessing the situation and taking what seems to be the logical decision. Everyone is fearful of looking bad when his portfolio contains a Satyam or a Nestle or an Enron. If word gets out, heads turn in the hallways and chatter follows. Clients demand explanations, and the situation can turn ugly. Investment managers prefer to retain popular stocks in their portfolio (whereby returns will surely remain average) rather than stick out their necks to vouch for something unpopular and scandal-ridden. Ergo, it’s an opportunity for individual investors.

Avoiding Lost Causes

If you find yourself contemplating investment in a crisis-stricken company, first try to gauge the odds of losing everything though total bankruptcy. This could occur because of ballooning costs related to the tragedy, or due to customers abandoning the brand altogether. But most often it relates to regulatory/political fallout. This binary “zero-or-one” kind of prediction determines the bulk of the risk you assume by investing.

In other words, try to assess the degree to which the interests of all stakeholders are aligned towards a speedy recovery. This includes customers, employees, management, suppliers, shareholders, bondholders, regulators and civic bodies. Each stakeholder has his own unique motivations and driving forces. Lose sight of these at your peril!

On one end of this spectrum are the natural calamities which affect businesses adversely. It’s no one’s fault that a hurricane hit a town with an oil refinery, thereby impairing inventory and stalling operations for many weeks. Nor is anyone to blame when an earthquake strikes a steel factory, causing very expensive maintenance downtime. Even when such events are not insured against, it is not uncommon for the local town, state or even central government to provide re-development aid or low-cost loans. It’s easy to see that the interests of all stakeholders are aligned. There will be a few quarters of reduced production and consequently sales, but over time, things will return to normal. BP oil spill (somewhat debatable) falls under this.

The other end of this spectrum might be a situation like falsifying records, siphoning off cash, or lying about permits, etc. In such a case, the regulatory authority might decide that the world would be better off without such a company, and will do everything in its power to obliterate it. Financial Technologies underwent such a treatment from 2012 to 2014 where it was systematically demolished. If any one key stakeholder truly wants the company gone, its chances of survival are indeed dim. Enron, Financial Technologies, and Lehman fall under this. An exception is Satyam where there was indisputable fraud yet which was bailed out through an acquisition.

Here, good judgment must come into play. Uber, for example, has been needling regulators for years, and has accumulated a remarkable track record of sidestepping them. One tactic is to temporarily subsidise cab fare, winning customer goodwill and applying this political pressure right back. Then again, these same aggrieved regulators may strike at a moment of weakness or some future downturn in consumer sentiments towards the company.

Deciphering Borderline Cases

For catastrophes in between these two extremes, there is a fair chance that the company may survive. For such situations, an investor must estimate the extent to which such a company will regain its former glory. If the catastrophe is not severe enough, the company bounces right back to where it started from.

It may take the form of:

  • – Too-big-to-fail players or institutions (Citibank)
  • – Big brands with plenty of customer goodwill (Nestle)
  • – Economic stalwarts whose collapse would ripple back devastatingly through their supply chains (with luck, Volkswagen)

Ironically, the crisis may even serve to jolt the management out of complacency, and suddenly begin to take tough decisions that they might otherwise have avoided. Examples include selling non-core assets, cutting wasteful costs and reaching out to fresh customers. Hence, the disruptive nature of the crisis can serve to unlock significant shareholder value that might otherwise never be realised.

Avoiding Pitfalls

Try to minimise your risks in such circumstances by watching out for common mistakes like:

  • – Investing more than you can safely afford to lose
  • – Recovery costs may escalate manifold (Exxon cleanup)
  • – Consumer pushback may spread unexpectedly to other brands/product lines
  • – Forced selling can take place when a market crash trips margin calls and squeezes short positions, irrespective of the price
  • – Investing in industries that you do not clearly understand. Someone with little knowledge of the financial sector, for example, would do well to steer clear of bank shares no matter how tempting the crisis
  • – Later disclosures may prove things to be much worse than originally anticipated (Satyam)

A “barbell strategy” is prudent, wherein you invest the bulk of your portfolio in highly liquid and less-risky assets like treasury bonds and index funds. Then you can feel confident taking calculated bets with your discretionary funds in hopes of earning outsized returns, while preserving the bulk of your capital.

In Summary

An individual investor will do well to patiently wait for the right catastrophe. Not only will they help stabilise markets and rebuild, but also potentially reap disproportionate profits. But remember, there will be a lot of discomfort during the initial months after the catastrophe – the price of the shares may gyrate massively.

The key is to be alert until you spot one that fits the bill, and remain patient during the recovery period.

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This article is for informational purposes only and does not constitute financial advice. It has been prepared without taking into account your objectives, financial situation or needs. Past performance is not indicative of future potential, and any changes in underlying assumptions may have a material effect on investment results. Hence do not rely on this information to make a financial or investment decision. Neither the authors nor publishers of The Leadership Review Magazine accept any liability for any error or omission on this web site or for any resulting loss or damage suffered by the recipient or any other person.

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Joseph A. Hopper is Director-India at the Theory of Constraints Institute and Dean at Sunstone Business School, India’s largest management certification for technology professionals. He has co-authored this article with Aniket Khera who is a co-founder of Willow Investment Management, LLC, a New York based boutique asset management firm specialising in investing in listed securities in India. He also teaches Finance and Economics related courses at Sunstone Business School and is an active early-stage investor.


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