The Unavoidables

by: Paulo Santos

There is an interesting phenomenon in the market. Sometimes, the market prices assets as if the outcome is already certain and unavoidable. As if overwhelming success or certain failure are no longer a matter of odds.

Obviously, when the market trades this way, the odds are really stacked against failure or success. But most times, the probability has not yet reached 100%. And if the market prices something as a certainty when that something is not certain, one might be in the presence of an interesting lottery ticket.

The past is littered with examples of this phenomenon. I'll cite a few.

National Vision

National Vision was (still is) an optical retailer. Back in 2002, National vision's fortunes were not famous. Saddled with a debt of around $120 million, National vision had most of its stores inside Wal-Mart (NYSE:WMT). Worse still; the Wal-Mart stores were the ones that were profitable. It so happened that Wal-Mart had also started its own optical chain, and was not renewing any of NVI's leases as these matured.

With $120 million in debt and making losses, the market lost all faith on NVI. Having 5 million outstanding shares, the stock traded down to $0.10 at the lowest, for just $500k in market capitalization. At this point, although the future looked bleak, NVI was producing around $25 million in free cash flow per year, and it still had enough years on the Wal-Mart leases that even with no change there was some doubt regarding the equity value. So the outcome was not an entire certainty, even though the market was pricing the unavoidability of a zero.

To make a long story short, NVI changed CEOs, the new CEO managed to improve stores and diversify somewhat, and before you know it 3 years later Berkshire Partners (no relation to Warren Buffett) bought it out at $7.25 per share, 72.5 times above its low. National Vision exists even today.

Reliant Resources

Back at the tail end of 2002, another event took place. After the December 2001 Enron bankruptcy, every IPP (Independent Power Producer) was the next Enron. Couple that kind of fear with the 2002 credit squeeze, and an IPP with billions in debt needing to be rolled over was the last thing any asset manager wanted to hold. Such was the case with Reliant Resources. Reliant Resources was a merchant IPP but it also had an utility component, so part of its earnings were stable. Yet, in the midst of all the fears it traded down to $1, where coincidentally it had a P/E of 1. In other words, it traded as if it were near-certain that it would be bankrupted by the unavailability of its creditors to refinance it.

But one needed to understand an obvious fact: banks are not in the business of bankrupting companies where such is avoidable, and when a company is profitable and likely will stay that way banks will favor refinancing it over taking ownership of power plants. So the outcome that the market was pricing as certain - a Reliant Resources bankruptcy - was far from certain.

No surprise, then, that the banks refinanced, the fear went away and Reliant resources ended up being more than a 10-bagger.


The fear of certain bankruptcy is not the only kind of unavoidable outcome the market sometimes prices. The long side also gets its examples. Take for instance Corvis in the middle of the tech bubble. Corvis was going to make the "all optical network" and every analyst in the market had it as buy or strong buy. The only problem? Corvis still had $0 in revenues, and it already carried a $30 billion market capitalization.

Obviously, Corvis making the kind of money needed to justify that kind of market capitalization was far from a certainty, and the result was incredible losses. Corvis ended up changing its name to Broadwing, and then got acquired by Level 3 for $1.39 billion, more than 95% below where it once traded.

What about today?

So we've talked about the past. But the present, which leads me to write this article, also has its own examples of things given as unavoidable, when in truth the outcomes are far from set in stone. I'll start with the obvious … (NASDAQ:AMZN)

The trouble with is not whether it can somehow dominate or whether it can somehow raise its margins again, bringing in a bounty of profits. The problem with is that it already discounts such outcomes as being certain, when for many reasons they aren't. For instance:

  • is losing its sales tax advantage;
  • has higher operational costs than Wal-Mart or Costco (NASDAQ:COST);
  • is threatened by the migration towards digital media, sold through OS-integrated stores which it doesn't control;
  • Etc.

There are many, many reasons why might end up not dominating retail and not getting back a decent operating margin. That alone is enough to have doubts when the stock trades with a $105 billion market cap on stupendous earnings multiples (130-2800 times, depending on which year one uses). Never mind that's earnings and estimates have been plunging for 2 years straight - hardly the kind of behavior you expect from a stock that trades as if victory is certain. is thus another clear example of the kind of stock trading as if the outcome is unavoidable, when clearly that's not the case. For sure, can somehow become the dominating force in retail, it can also increase margins. Maybe that outcome is even the most likely one - but it's far from certain, and the price it trades at discounts certainty - so the stock is a short.


THQ has been a dog for so long that people have forgotten it's able to do anything other than bark (and roll over). Sure, the fundamental evolution has been terrible, revenues are imploding, losses are mounting and there's the very real possibility that THQ might go bankrupt with cash draining fast.

But is bankruptcy a certainty? It isn't. The company is still EBITDA positive, there are no enormous debt repayments in the short term, and even after all the revenue it lost, it's still expected to have revenues of around half a billion dollars in FY2014.

A lot can still happen, yet the company already trades as if a near-term bankruptcy is imminent, as can be gleaned from its $8 million or so market capitalization. This is one of those cases where just avoiding bankruptcy and staying as a solvent entity a few years down the road would mean a tremendous reward for shareholders.

Can it go bankrupt, then? Yes it can. Is it certain? Not at all. For a more detailed look into THQI, I recommend reading J Mintzmyer's article, "Tremendous Upside Potential On A THQ Bet". In short, THQI is a decent long-shot opportunity from the long side.


As a conclusion, I could say that sometimes the market prices stocks in such a way that, even while what the market expects is likely, the market prices in near full certainty. This opens up a probability-weighted chance to make money for an investor. For instance, we could say trades as if it were a lottery stock with a 95% chance of paying $110 billion, when the chance most likely is just 30-40%. On the other hand, THQI trades as a lottery stock with 8% chance of paying, say, $100 million, when in fact the chance might well be around 20, 30%.

Obviously not much money can be bet in these situations, because although they're most likely mispriced, the odds are still that the (expected but still uncertain) outcome will produce itself.

Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also long THQI as of today.