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Lessons From American Home Mortgage
Related Stocks:
AHMIQ.PK08/09/2007:
Investors in American Home Mortgage were dealt a nasty blow last week as their stock became the latest victim of a deteriorating credit environment. The mortgage lender's stock plunged 84% Tuesday on news it was considering liquidation. On Thursday the company abruptly announced it would shutter its lending business and lay off some 6,000 employees. The company filed for bankruptcy Monday. The stock, which traded over $20 in June, is now listed on the pink sheets with a value of roughly 35 cents.
While it may seem like cold comfort to investors that lost on it, the American Home Mortgage disaster offers some investment lessons. Learning from them may help in avoiding similar portfolio burns in the future. The deterioration of AHM surprised many, but clues of trouble had been brewing. With the benefit of 20/20 hindsight, let's first take a look back at the possible warning signs.
On June 29, the company pulled 2007 guidance and announced that delinquent payments would lead to a second-quarter loss. It was probably no coincidence that the announcement was made on a Friday. Shares dropped 12% on the news. The company was nonspecific about the reason for this pulled guidance -- a definite red flag.
On July 18, the stock mysteriously went into a 20% free fall and the NYSE asked the company for comment. Once again, management remained elusive, stating that they “do not comment on rumors.” By the next day, the alleged rumor that Lehman was going to shut down the company’s credit line was widely published in the media. The company denied the rumor.
Despite the invalidity of the credit line rumors, the stock price did not recover. Could some sellers have known that a bigger problem was looming? The lack of recovery in the company’s stock was a last chance for long investors to cut losses.
By July 30, the full truth was revealed that the company was buried in margin calls and would be unable to cover. Unfortunately, by then it was too late.
Trading Lessons from AHM
Be Wary of Bad Press Relations. Usually when a company gives the press a cold shoulder, it's trying to cover up serious damage. The lack of information in American Home Mortgage’s press comments on the credit rumors and pulled guidance should have been a cause of concern to anyone holding a long position. Even Jim Cramer, in his book Real Money: Sane Investing in an Insane World, discusses “vagueness” as a screaming sell indicator (page 242).
Don’t Underestimate the Cycle. It seems that many overly bullish investors, including myself, bought into American Home Mortgage in April and May thinking that the mortgage mayhem had stabilized. In regards to the first quarter, CEO Michael Strauss commented, “It does appear that the secondary market is stabilizing.”
What I and these other hopeful investors overlooked is the fact that the underlying fundamental problems were still in the system. Despite the temporary relief, rising interest rates, declining home prices and the resetting of adjustable-rate mortgages, or ARMs, continued to lurk. When the subprime-mortgage beast roared once again, the optimism got crushed.
Cut Losses. All veteran traders seem to repeat this one over and over: Cut losses, cut losses, cut losses. It seems to be one of the most consistent rules among traders. When a company’s stock goes in a nosedive, it is usually hard to spot a bottom. If the fundamental reason for the nosedive is macroeconomic, there will be even more downward momentum. By determining your exit points of a trade before opening a position, you can prevent a considerable amount of pain if, of course, you stick to those predetermined exits.
Full Disclosure: At the time of this writing, Winston does not hold a position in the discussed stock.
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