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Broken Windows Thesis is a sociological theory that explains social disorder. The theory was first published in 1982 by James Q. Wilson and George L. Kelling while working at Harvard. The theory is used to describe a process that over time, if something is not attended to it falls into disarray. This usually starts with a negative social phenomenon that plants a seed of doubt in the mind of its observers.

Broken Windows

"Consider a building with a few broken windows. If the windows are not repaired, the tendency is for vandals to break a few more windows. Eventually, they may even break into the building, and if it's unoccupied, perhaps become squatters or light fires inside. Or consider a sidewalk. Some litter accumulates. Soon, more litter accumulates. Eventually, people even start leaving bags of trash from take-out restaurants there or even break into cars."

The theory states that until someone comes along and fixes the issues then the problem will only get worse. Not only does someone have to fix the issue but the rest of the community has to acknowledge that the problem has been fixed or at least is being attended to.

The Activist Investor

In the stock market we see this quite often with activist investors. A stock over time has been forgotten or ignored. Perhaps a company received negative press and the price drops. Whatever the trigger may be for a sell-off, the stock price simply does not recover. Not until an activist investor comes along; the hedge fund manager or the high net worth person who buys into a company that does not necessarily have anything wrong with it except for sentiment.

The activist investor then has a press release, stating they have taken a position in a company that the general market has disregarded. The common statement is that; the activist investor believes the stock is undervalued. The price jumps 10% after the announcement. Why? Simply, because someone has come along and says to the community that he is going to "fix what is broken".

The Process

This process can start in a couple of ways: a stock can simply be abandoned; there was not a catalyst for the decrease in stock price; or investors simply saw better opportunity elsewhere. Over time more and more stockholders may become discontent with the price action and sell their position. As there were more sellers than buyers, the stock price would slowly decline.

Stagnation

A similar process is that the stock price trades sideways for some time. We see this with dividend paying blue-chip stocks quite often; stocks such as Intel (NASDAQ:INTC), General Electric (NYSE:GE) and Microsoft (NASDAQ:MSFT). All great companies that have had shareholders move on, looking for greener pastures. There is not necessarily anything wrong with these companies. The price has traded within a range because people are not interested in them as much. Because they do have solid dividends people still buy into them for income. No one has come along saying they are going to fix what is broken. Instead the windows quietly get fixed as the caretakers fix the windows one by one as they are broken.

Catalyst

The second and more noticeable is the company that has had a negative sentiment associated with it. The best example of this is Apple (NASDAQ:AAPL). The stock ran to $700.00 and then it happened. Questions about margin, supply chains, product innovation started to rise. A couple windows started to break. The stock started to fall. There was a large amount of fear pertaining to the stock price. When confirmations of the rumors were released the price fell even more. More people came along, saw the windows and decided to break even more windows.

Along came David Einhorn, someone who already had a position in the community. Mr. Einhorn saw "value" in the company and wanted it returned to shareholders. Six weeks after Mr. Einhorn rescinded his lawsuit; sure enough Apple raised its dividend 15% to $3.05 and announced the largest stock buyback in history at $100 Billion through 2015. It was announced that someone was going to fix the windows and the breakage stopped. On April 19th, Apple hit its low of $385.10. On April 23rd, after the announcement of the dividend and buyback increases, the price has steadily increased from its 52 week low.

Conclusions

We already know that a stock price goes down when there are more sellers than buyers. This can happen in two ways. The stock is slowly forgotten as the community sees other opportunities. Or there is a negative sentiment that builds along with fear lowering the price considerably. In either case the stock needs someone to come along and announce that they are going to fix the issue with the stock which ignites confidence again within the community.

Activist investors may step in when the stock has fallen far enough. They will initiate a position and let the trading community know. The stock will usually go up and is no longer a bargain.

In order to prevent the stock price from falling, management needs to remind investors that they are still there and that they have a great company with great products. Also, if something bad does happen, then management needs to be the first ones to inform everyone, letting the investors know that a couple windows may be broken, but they are aware and in the process of fixing them.

Source: Price Volatility: Broken Windows And Activist Investors