- Volkswagen air emissions scandal
- The “defeat device”
- How could have a talented money manager benefited from the EPA announcement?
- Secondary plays
Lately, we have been talking about the efficiency and inefficiency of the markets, and about if it is possible to time when to enter and exit them. In one of our last posts, “The Eternal rivalry in Portfolio Management,” I showed some of the arguments against Active Management and how the majority of active managers lose money due to their inability to properly time the markets and due to their inner greed and fear, product of our human nature.
However, the discovery of a terrible practice that Volkswagen has been performing since 2009 can be used to illustrate how the skilled money managers can take advantage of developments in the business world in order to improve their ROI. This is not an article to support active management, it is one to show that in determined moments, some active management can make a huge different in the returns of a portfolio.
We, at OpSeeker, try to be as impartial as possible. Despite of our support to passive management as the adequate investment philosophy for the vast majority of people, we understand that active management can definitely bring above average risk-adjusted returns. Nevertheless, you should always keep in mind that most active management plays require a few things. First, a deep understanding of how the different market forces work, second, the skills to perform the trades, and finally, the time to follow up. Since we believe that this is almost never the case, even when discussing professional money managers, we still side the passive management crew. Another problem that comes when giving an example of how a short-time trading play worked is that we tend to forget how many didn’t work but seemed as robust and logical as the one that did. Having all this in mind, I still want to share with you the Volkswagen case.
Volkswagen, the story of a fraudster
First of all, I think it is quite important to understand the matter at stake, so I am going to give a summary of the development in the Volkswagen “defeat device” case.
The issue started over a year ago after a study conducted by West Virginia University and commissioned by the International Council on Clean Transportation. The research found emission levels that did not correspond with the ones claimed by Volkswagen in two of its diesel-engine vehicles. Despite of Volkswagen’s initial statement, in which the company pointed to some technical issues and unexpected test conditions as the main reasons of the negative results, in December of 2014 Volkswagen voluntarily recalled almost half a million vehicles to address the emissions matter.
This past May, CARB and EPA conducted a follow-up test after the Volkswagen’s recall both in-lab and on the road. The tests showed that the recall was not successful. Volkswagen was not able to explain why the results were so negative, and the two agencies (CARB and EPA) let Volkswagen know that the VWs 2016 Diesel line up will not be able to enter the U.S. market.
Its only then, on this past September 3rd, when Volkswagen admits that the diesel cars were manufactured with a particular software that allowed them to pass the emission tests despite of the high levels of NOx that these engines were producing.
The “defeat device”
A defeat device is an auxiliary emission control device (AECD) that hinders the effectiveness of the emission control system under a particular set of conditions that can be expected to be encountered in the normal operation of a vehicle.
The 18th of September the EPA disclosed that Volkswagen had included a defeat device in over 480,000 vehicles in the U.S. You can read the full disclosure here: EPA statement
In EPA’s own words, Volkswagen did the following:
“Specifically, VW manufactured and installed software in the electronic control module (ECM) of these vehicles that sensed whether the vehicle was being tested for compliance with EPA emission standard. For ease of reference, the EPA is calling this the ‘switch.’ The ‘switch’ senses whether the vehicle is being tested or not based on various inputs including the position of the steering wheel, vehicles speed, the duration of the engine’s operation, and barometric pressure…”
This means that VW violated the Clean Air Act and that the department of justice can enforce up to $37,500 in civil fines per vehicle for a total of over $18 billion.
On September 22nd Volkswagen announceD that 11 million diesel cars manufactured and sold worldwide have the “defeat device” software that evades emission testing. The company also communicated that it has set 7.3 billion dollars to cover for the cost of fixing the cars.
How could have a talented money manager benefited from the EPA announcement?
An interested reader could check a chart of the stock price of Volkswagen to see how much the company has dropped since the EPA released its statement.
As you can see in the chart, on the 18th the company closed at €161.35 and two days later it closed at €111.20. In theory, someone could have shorted at around €160 euros and buy back at around €110 making around 30% return (if you don’t know what I mean by “could have shorted” click here: short selling). However, it was not as simple as this. The EPA release was on the 18th of September, but it was at 12:00 PM New York time, 18:00 PM in Germany, the European markets were already closed. This means that if you wanted to short the stock after the news you would have to wait until the market opened next day, and since the 18th was Friday, you would have to wait the whole weekend. However, the selling pressure was so high on Monday that the market opened at €140.95, 13% lower than the previous closing price.
However, this was not the only way of playing the Volkswagen stock. A skilful and knowledgeable money manager would know that Volkswagen trades in the U.S. market through an ADR, VLKAY. The following chart shows the price performance of this particular ADR.
The markets were not efficient after the EPA release, most of the participants failed to acknowledge the huge deal that this represented, and the price for the Volkswagen ADR didn’t show any concern. A portfolio manager with a team following the different sectors, that knew about this particular release and that judged the information properly could have shorted shares at a price above 36, two days later the price of that same investment was around 25. That would have been a profit of 30%.
If we think that this trading opportunity occurred because of the slow reaction of the markets to a particular release concerning the biggest automaker in the world, we can only imagine how many other opportunities can be present in other stocks that are less followed by analysts.
Was this the only play?
No, it was not. Other secondary plays could have been exploited. Let’s illustrate a couple of them (they are, in essence, the same).
These two charts show the evolution of the price of palladium and platinum last week. Palladium scored its largest price appreciation since December 2011, increasing its value over 9%. Platinum in the other hand fell to a six-year low at $925 per ounce. Why?
Palladium and platinum are both used in catalytic converters. These devices help control toxic emissions from cars. There is a catch though; palladium is used for gasoline vehicles and platinum for diesel vehicles. The markets feel that the Volkswagen scandal could hurt the appetite for diesel cars (they represent 1/3 of the global demand for platinum), which was already diminishing due to the price of petroleum and the high amount of noxious gases that these engines emanate. At the same time, diesel loss is gasoline gain, which translates in a higher than expected demand for palladium, hence the price appreciation.
These are speculative market plays, and they entail a great deal of risk. However, an experience and knowledgeable portfolio manager could have reacted to the announcement early. Buying palladium and selling platinum would have yielded pretty hefty returns.
The reader needs to understand that post hoc the above-mentioned plays look fairly simple, but it is far from that. The levels of uncertainty after any event are really high, and keeping a cold head and firm hands it’s a talent that only few can master, and even the masters tend to make mistakes. Experience, knowledge and talent can help to understand to which levels a security will tend to move after a particular event, however, it is never certain.
I hope you enjoyed this reading! I might have been too fast to call this the disaster of the month, but I feel that with only a few more days in September we are pretty safe with this call!
The post Volkswagen Scandal – Trade Opportunities appeared first on OpSeeker.
