The year was 1997. The company was Apple (AAPL, Financial), which was hardly the stock market darling it is today. Its shares traded around $4.50 each and the company was on the brink of bankruptcy.
As Stephen Horan, Robert R. Johnson and Thomas Robinson pointed out in their 2014 book, "Strategic Value Investing: Practical Techniques of Leading Value Investors," Apple shares went on reach $700 each (before a 7 for 1 split), which represented a gain of 15,000%. Obviously, then, there are wonderful opportunities in distressed investing, for investors who can stomach the risk.
Their goal in chapter 14 was to teach strategic value investors how to use fundamental principles to detect unseen opportunities while avoiding disaster. They wrote, “Be warned, however, distressed investing is not for the faint of heart. That it is sometimes pejoratively referred to as vulture investing reflects the cold analytical skills and steely fortitude one must have to sift through the remains of corporate road kill.”
Let’s look at those principles and best practices.
Distress versus bankruptcy
First principle: Know the language. While "distress" is commonly associated with bankruptcy, a company can be distressed without having to file for bankruptcy.
There are also different types of bankruptcy, the most common of which is Chapter 11 protection. In this form of distress, a company continues to operate while it makes or tries to make a deal with its creditors.
Insolvency versus illiquidity
The first of these terms, insolvency, refers to cases where the debts of a firm are more than its assets, which means negative equity for shareholders. It is also a balance sheet concept.
Turning to illiquidity, this refers to a company that does not have enough cash flow to cover its current debt service obligations. This makes it an income statement or cash flow concept.
Other variations include the possibility that a company can be insolvent, but liquid (for a limited time). Many front-page debates about pensions refer to funds that do not have enough to meet their long-term obligations but are able to meet their current needs.
Should we invest in firms emerging from bankruptcy?
The authors said, “Distressed investing is contrarian to the extreme. You must be willing to buy when literally everyone else is selling and saying, 'There is no way out of this!'” They point to the strategy of Howard Marks (Trades, Portfolio), who would sit on cash for long periods, waiting for distressed opportunities.
These facts suggest most of us should not invest in them:
- Forty percent of companies that filed for bankruptcy experienced operating losses for another three years.
- Two-thirds of those firms end up filing for bankruptcy a second time.
- They underperform their peers and generally don’t meet targets set out in reorganization plans.
To avoid such investment dogs, the authors urged investors to watch for these positive signs after Chapter 11:
- New management is installed.
- Incorporation is done in the state of Delaware, which allows takeover bids.
- A prepackaged bankruptcy is in place.
- A long bankruptcy process, if it has not been prepackaged.
- Shareholders who held positions before Chapter 11 are staying invested.
Warrants and convertible bonds
Many distressed companies get into trouble because they cannot gain access to capital markets, which leads to liquidity problems, and to financial distress. To deal with this constraint, they may turn to warrants or convertible bonds to raise cash.
The authors called warrants the equivalent of long-term call options. Warrant holders (buyers) are entitled to purchase common shares at a fixed price in the future. Convertible bonds provide bondholders with the right to exchange their bonds for common stock, at a fixed ratio. They added, “Therefore, warrants and convertible bonds are ways to give potential investors some upside potential and limit their downside risk.”
And, “So, if you are investing in distressed situations, do not discount the valuable role that warrants and convertible bonds can play in helping an otherwise well-run firm recover from financial exigency.”
What is that distressed security worth?
The starting point for valuing a distressed stock or other security, is to asses where its debt stands in the phases leading to bankruptcy:
- The debt will continue to be a performing loan (and not go into distress).
- Become part of a voluntary restructuring.
- Be part of a Chapter 11 reorganization.
- In Chapter 7 liquidation.
The further down the ladder, obviously, the greater the risk and the greater the need for yield. To illustrate, they created this example for their book:
To arrive at a valuation, an investor multiplies each of the likelihoods by the estimated recovery rates across all four scenarios and then adds up the outcomes (expected recovery rates). In this case, the sum is 61%, i.e., there is a 61% chance the investor will recover their loaned capital. The authors went on to apply a 30% margin of safety, and that would imply a viable purchase price of about 36 cents on the dollar.
Valuation multiples
When assessing distressed securities, the authors recommended using an enterprise value (EV) approach, because the equity alone probably has little or no value. Enterprise value equals the sum of a company’s equity and its debt.
One proxy for value is EV-to-Ebitda; however, Ebitda does not account for the capital spending needed to maintain the value of the assets and therefore overestimates the amount of free cash flow available for shareholders. Thus, they argued, EV-to-FCFF is a better measure of “the net sustainable cash flow to the firm.”
Investors searching for distressed situations may be described as deep value investors, since deep value is often available only in distressed situations. Technically, if the share price is less than a company’s net working capital, after subtracting all debt, it is a deep value deal. One commonly used tool to analyze such situations is the price to net working capital ratio.
Derivatives
While Warren Buffett (Trades, Portfolio) has called derivatives “weapons of mass destruction,” he has also used them in the Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) portfolio. In the leadup to the Financial Crisis, the company sold $4.2 billion worth of put options that would expire between 2009 and 2027. He sold them on the stock indices, which is the equivalent of selling insurance on the broad equities markets. Doing that provided Buffett with $4.2 billion of additional capital to invest.
According to the authors, “In 2008, Buffett decided to use put options as a way to take advantage of the distressed investing environment rather than buying stocks outright.” The guru expected that economic conditions would improve eventually, and that there was less than a 1% chance the options would be exercised against him.
Conclusion
Think of distressed investing as an extreme form of value investing. While it uses many of the same principles used by more prudent investors, there is a knowledge base that applies specifically to distressed situations.
There is also the matter of knowing the terminology, that “insolvency” is different than “illiquidity,” and it is important that investors know what stage a distressed debt is in. As if that weren’t enough, the authors threw in another difference affecting distressed investing:
“For example, the outcomes are often based on idiosyncratic decisions of individuals or bankruptcy courts rather than long-term trends. In those situations, distressed investing can be more akin to speculation than investing. The disciplined investor who is willing to buck conventional wisdom and rely on the weight of his or her analysis, however, stands to profit handsomely.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:Ă‚
Strategic Value Investing: Choosing Valuation Models
Strategic Value Investing: Income and Taxes
Strategic Value Investing: Diversification
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
