On the afternoon of August 5, 2010, a company called American Public Education Industries (ticker APEI) reported 2Q earnings.  The next morning, the stock fell by 30%, from $45 to $30, and over the next few days extended its slide to $25, for a 45% total decline.

APEI is an example of what Nassim Taleb calls a “Black Swan”:  a seemingly unpredictable event with an extreme outcome.  Speaking technically, I estimate the plunge in APEI’s stock price was equivalent to a 7-standard deviation event, which should in theory happen only once every 400 billion years or so (for technically oriented readers, this estimate assumes the implied volatility in the stock prior to the selloff was approximately 40%).  Put differently, investors seem to have underestimated the degree of risk -- a good working definition of a stock market Black Swan.  

People have grown accustomed to talking about Black Swans in the context of the capital markets crash and global downturn of the last few years, whose aftershocks we continue to feel.  But Black Swans don’t have to impact the whole world.  They happen all the time on a smaller scale, affecting individual industries, companies, and people; APEI is just one of many examples.  In Stalking the Black Swan, I describe my experience with Black Swans in the stock market and explain how as an analyst I tried to anticipate the risk or, when I wasn’t able to foresee the shock, how I reacted.

In order to learn about the cause of Black Swans, let’s diagnose the causes of APEI’s dramatic selloff.

For some background, the company provides online postsecondary education, with a special focus on the needs of the military.  APEI’s business originated with the military (it’s founder was a Marine), and today military students accounts for 75% of the company’s business.  In recent years, the company started offering courses to civilians, and it recently announced a deal to provide online educational services to Wal-Mart’s associates – a real coup.  The company’s earnings had grown quite rapidly in recent years, and sellside analysts were forecasting continued rapid EPS growth in excess of 20%, with price targets of $60 or higher.

Of course, no-one knew for sure how quickly the company’s earnings would grow.  While there wasn’t much doubt about its military franchise, analysts worried about competition, especially in the company’s more recent foray into civilian niches.  And the Wal-Mart deal wouldn’t produce results until 2011.  We can understand the $45 stock price as the expected value across a range of different growth scenarios, as illustrated below:

Exhibit 1: APEI's $45 Stock Price Reflected High Odds on the Most Favorable Growth Scenario

Exhibit 2: APEI's $25 Stock Price Reflected High Odds on the Least Favorable Growth Scenario

My diagnosis:  APEI’s Black Swan was a result of a “fragile” consensus outlook on the stock, in this case meaning that the opinions of a large number of analysts and investors relied heavily on management guidance, rather than on their own independent judgment or homework.  When management withdrew its guidance, the analysts and investors had no basis to continue to forecast strong growth, so they reverted to a significantly more conservative outlook.

It is tempting to blame the analysts for not having a stronger view on the business.  But in their defense, APEI’s business is obscure:  there are no other public companies with similar business models, and there is no public data on military deployments.  Further, like everyone else, analysts have limited time – in my experience, there is not enough time for an in-depth study of every individual company an analyst covers.

There are many other examples of how a “fragile” consensus can lead to Black Swan-like outcomes when the consensus turns out to be wrong.  Think of how many investors, regulators, and financial institutions relied on AAA ratings on subprime mortgage-backed securities.   Everyone depended on the opinions of three rating agencies, Moody’s, S&P, and to a lesser extent, Fitch.  When the ratings were proved wrong, the havoc in the markets was extreme.

For management teams who would like to avoid the kind of Black Swan that afflicted APEI, it might be worth considering whether or not to provide earnings guidance.  For companies operating in obscure industries, where analysts have trouble coming to strong independent views, changes in guidance are likely to contribute to extreme volatility in the stock price, and damage management credibility as well.