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Lottery Tickets


prunes
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I'm curious what people's experiences have been like with what I'm going to refer to as "lottery ticket" stocks. Distressed securities with favorable risk/reward profiles but with with a high likelihood of loss of principal, e.g. (shamelessly cribbed from Michael Bigger's blog) PLUG, APP, CRMB, etc. If I had the capital I'd perhaps be interested in buying a basket of these stocks but feel that with how much diversification I'd need to feel comfortable that too much would be eaten up in transaction costs. Instead I adhere to the maxim of not buying a shares in a company unless you'd feel comfortable owning it in its entirety for several years.

 

For those of you that deal in this arena, I'm curious what approach you typically take to position sizing, how well in practice this strategy works out, and so on.

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I don't think those stocks offer favorable risk/reward profiles. All three are unprofitable, PLUG has negative gross margins and APP has negative tangible book value.

 

http://schwert.ssb.rochester.edu/f532/rnm_value_2012.pdf (On average, profitable companies outperform unprofitable companies.)

 

http://www.bengrahaminvesting.ca/Research/Papers/Griffin/Does_Book-to-Market_Equity_Proxy_for_Distress_Risk.pdf (Cheap stocks outperform on average, and distressed stocks underperform on average. You can't just buy distressed stocks and assume they are cheap.)

 

http://www.russell.com/indexes/documents/research/defensive-equity-is-the-market-mispricing-risk.pdf (High beta stocks are systematically overpriced, since some investors seek out lottery tickets indiscriminately.)

 

If you are interested in distressed companies, I'd suggest debt and hybrid securities as a more attractive area to concentrate on.

 

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Hmmmm:

 

There are a lot of "lottery tickets" out there, that is for sure.

 

I think they tend to be concentrated in tech, medicine, and things where if their product works, they will make a lot of money.  Some property development is like this...

 

There are other stocks though that might even be cheap and have "lottery tickets" attached to them.  For example, MHGU owns an interest in vacant land in the Bahamas.  It appears to be very nice land and is beach front property.  If it gets developed, it should be worth a LOT of money.  The amount would be very significant in relation to their market cap.

 

Another restaurant company with a "lottery ticket" attached is ARK Restaurants (ARKR).  They now own a 15% interest in the Meadowlands race track.  There is speculation that the Meadowlands will be allowed to become a "racino".  If that happens, ARKR's interest will almost certainly be worth a LOT more than what they paid.  Additionally, they will control all the food & beverage for a significantly increased location!

 

I have several other "lottery ticket" stocks, but I think there are two good examples.

 

The other nice thing is that these are both "value" stocks.  MHGU is making a lot of $ relative to it's market cap, and ARKR is probably value play too...

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I used to participate in some lottery type investments and would have about 1% of my portfolio in each lottery stock.  Results were mixed.

 

When I was at a company that analyzed new drug companies and their pipelines, I had to guess the outcomes of clinical trials and what regulators would do. Most of the drug companies failed and I don't think anyone could have picked out the few successful companies with a high degree of certainty. 

 

I had better luck on lottery stocks with legal or regulatory issues.

 

Nowadays I run a more concentrated portfolio of 10-20 undervalued (or at least I hope they are) stocks. I don't think the lottery stocks were worth it with the small position sizes because the outcomes barely moved the needle.

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There are alot of these in biotech and in real estate development/land.  A friend of mine used to be a biotech analyst and has successfully invested in these.  He tries to find these where a trial has failed but has a fixable issue.  I have not invested in these because I typically like to find a value stock with a free lottery ticket attached.  Examples include Fiat (with the option to purchase Chrysler), FLL (an option to build a hotel by there latest casino purchase) or RDI (with its real estate portfolio). 

 

Packer

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Lottery tickets do not have to be long positions in depressed companies; call or put options qualify as well. And given that the only consistent `winner`in a lottery is the sponsor; that should tell you something!

 

Writing out-of-the-money calls would be a lot more reliable  ;)

Sell the lottery tickets, don`t buy them.

   

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