Cornwall Capital was founded in 2003 by two young people who were not in the mainstream - Charlie Ledley, and Gammy Mak. I say they were out of the mainstream because they were not financial professionals from a scientific background, but they were full of imagination, and a keen insight into the market. Their insight is evident in the transactions of First Capital Financial.
Case Background
Before betting that the subprime mortgage market would collapse, Cornwall Capital first noticed a credit card business company, First Capital Financial. Throughout the 1990s and early 2000s, First Capital Financial claimed that it had better tools than other firms for analyzing the creditworthiness of subprime credit card users and pricing the risk of lending to them, and the market bought that claim.
But in July 2002, First Capital Financial's stock fell 60% in two days after the company voluntarily disclosed a disagreement between them and two government regulators: How much capital did they need to set aside for potential subprime losses? Apparently the market began to suspect that the regulators believed that First Capital Financial had too little capital in reserve, that there might be fraud in it, and were prepared to penalize the company.
Over the next 6 months, while First Capital Financial continued to make profits at a phenomenal rate, the market still did not know if there was fraud involved and First Capital Financial's share price fluctuated slightly around $30.
After a period of research, two young men from Cornwall Capital came to the conclusion that the company was either fraudulent and its stock would be worthless, or honest and its share price should be around $60 per share. Charlie and Gammy tend to think that First Capital Financial is honest, but it's not that certain.
Suppose you have a 60% probability that First Capital Financial is honest, what should you do? What is the potential gain?
Trading Strategy 1 - Buy outright
Assuming we have $30,000 to buy 1,000 shares of First Capital Financial Corporation stock outright, then
Scenario 1: Company is fraudulent, stock price = 0, total market cap = 0*1000 = $0
Scenario 2: Company is honest, stock price = 60, total market cap = 60*1000 = $60,000
Since we believe that case 2 has a 60% probability of occurring, the expected total market value = 0 * 40% + 60,000 * 60% = $36,000
Our expected rate of return = (36,000 - 30,000) / 30, 000 * 100% = 20%
The higher the probability of believing that First Capital Financial is honest, the higher our expected rate of return. If one is 100% sure that they are honest, then the expected return can be as high as 100%.
Trading Strategy 2 - Options Trading
Cornwall Capital has found that there are still First Capital Financial call options trading in the market. One of them goes like this: The party holding the call option has the right to buy the company's stock for $40 over the next 2 1/2 years, so how much is the option worth?
Let's continue with the previous analysis, before the expiration date when the conclusion must be reached whether the company is fraudulent or not.
Case 1: The company is fraudulent, stock price = 0, option price = 0
Case 2: The company is honest, stock price = 0, option price = 60 - 40 = $20
Then the expected value of the option at the expiration date = 0 * 40% + 20 * 60% = $12.
Converting from the expected value at expiration to today's option price is relatively complicated, especially since the stock option is an American-style option. Let's give a straightforward estimate of the result, the option price today is about $10.
What is the market actually trading at? A mere $3.25!
Why? It turns out that the market did not use event analysis to price First Capital Financial's options; the market simply applied the Black-Scholes Model for options and assumed that First Capital Financial's stock price fluctuations, like other stocks, fit a normal distribution: over the next two and a half years: the probability of the stock price being $35 per share is greater than the probability of the stock price being 40 per share, the probability of $40 per share is greater than the probability of $45 per share, and so on.
Clearly, the market was mispriced.
Cornwall Capital Management immediately buys 8,000 long-term stock options. Total 8,000 * 3.25 = $26,000.
Shortly thereafter, First Capital Financial's problems were clarified by regulators, the stock price soared, the option price eventually rose 20 times, and Cornwall Capital Management's $26,000 option position was now worth $526,000.
In Summary
Cornwall Capital did two things: first they researched and concluded that the probability of First Capital Financial being honest was still pretty high; second, they found the option that the market had mispriced, and based on the pricing of that option, First Capital Financial only needed about a 20% probability of being honest to be worth the bet.
Fundamental analysis + product selection and exponential amplification of the trade win rate is what made this trade successful for Cornwall Capital, and the results were as expected due to that.
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