Wednesday, June 22, 2011

Investing in Lawsuits

Ted Frank is what you might call a "professional objector," which means he is in the business of objecting to class action settlements. Ted had an interesting investment angle leading up to the outcome of the Supreme Court's decision in Wal Mart v. Dukes -- a massive class action case against Wal Mart alleging gender discrimination. Here was his premise:

Over the years I've been surprised when the stock market strongly reacted to judicial decisions that seemed like obvious outcomes. This surprises me: I don't have inside information; institutional investors have the ability to process the same public information that I do; the efficient market hypothesis predicts that this public information should already be reflected in the stock price; thus, if I can predict a ruling, the market can, too, and shouldn't treat it as a surprise when, say, the Illinois Supreme Court reverses a multi-billion-dollar judgment against Philip Morris, which bounced over 5% that week in December 2005. But apparently, the trial lawyer strategy to artificially depress stock prices to pressure defendants into settlements has an effect of creating market inefficiencies.

I'm very confident that Wal-Mart v. Dukes will result in a reversal of the class certification in the enormous multi-billion dollar class action against it. But the things that make me confident in that result—the briefs, the tenor of the oral argument, the language in AT&T Mobility v. Concepcion about the importance of protecting the rights of unnamed class members—did not produce movement in the market price of Wal-Mart stock. This leads me to suspect that the market is undervaluing the probability of reversal, and will be surprised when the Supreme Court does reverse later this month.
It's always bothered me when economists make clever predictions but aren't willing to bet on them, Julian Simon a notable exception. Here's a hypothesis that won't take twenty years to resolve; if I'm right, aren't I stupid if I don't make a quick profit on this predicted market inefficiency. So I've put my money where my mouth is: with the dip in stock prices last week, I invested a bit over 10% of my net worth in a leveraged bet that WMT stock will bounce this month when the Supreme Court releases its decision through purchases of July and September out-of-the-money call contracts.

How did it work out?  Not very well.  According to Ted:

In the stock market, you can be wrong and make money, and right and lose money. It's better to be lucky than good. I'll liquidate today, and take a loss of over half my bet. C'est la guerre. I've made bigger financial mistakes in my life; I've had single trips to Las Vegas where I made more money than I lost on this three-week bet. (Heck, I'm an economist who understands opportunity cost. I lose more money than this every year I devote to the Center for Class Action Fairness instead of being a for-profit lawyer.)

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