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In this note of The Turnaround Letter’s series on investing in distressed securities, we focus on how to take the next step: digging into your list of candidates to find the few that look most promising.
The ultimate goal in evaluating a distressed security is answering this question: is there anything here worth investing in? To help answer this question, first examine why the company is distressed:
- Separating causes of distress from symptoms of distress.
- At the heart of distress is change.
- In most cases, the underlying cause is poor or dishonest management.
- Symptoms flow from the causes. The most common symptoms include deteriorating financial results.
The ultimate goal in evaluating a distressed security is answering this question: is there anything here worth investing in? If not (perhaps the company has so little value that even the most senior traded bond would not have much recovery), then it’s time to move on. But if there is meaningful value, then it’s time to look deeper.
The first step in evaluating your candidate security is understanding why the company is distressed. This will help you decide if the securities have a reasonable chance of recovery and what they might eventually be worth. At the heart of distress is change. A completely static environment rarely produces problems. It is when the environment changes (for the worse) that companies’ weaknesses get exposed. The faster and more profound the changes, the deeper the distress. Examples might include an extremely sharp or rare industry or economic downturn, an unexpected legal or regulatory change, a highly-disruptive new technology or a change in customer tastes or buying habits.
We separate causes of distress from symptoms of distress. In most cases, the underlying cause of distress is poor or dishonest management. At a minimum, management is responsible for keeping a company healthy enough to maintain its operations and meet its financial obligations. Each business and industry is prone to up- and down-cycles. It is management’s duty to operate and capitalize its business to survive during the down-cycles and reasonably prosper in the up-cycles.
At a higher level, it is management’s job to adapt to change. While some changes occur so quickly that even well-run companies can be overwhelmed, it is management’s responsibility to identify and meet the challenges of its evolving environment. Poor managements can lose sight of these responsibilities. They finance aggressive growth or acquisitions with debt, overpay for acquisitions at cyclical peaks, expand into unfamiliar businesses to “diversify,” fail to control costs and fail to innovate to keep up with customer demands. Each of these examples can overextend the company’s financial wherewithal and threatens its future when change arrives.
Dishonest managements may commit outright fraud. This typically involves hiding chronically weak financial results with accounting tricks. When the fraud is discovered, the company’s access to cash can evaporate and it may be left with a large debt burden that it is unable to service. Other types of dishonesty may include corruption or serious conflicts of interest. These types of fraud can drain valuable cash, create internal disarray and drive honest talent elsewhere. Symptoms flow from the causes. The most common symptoms include the following:
- declining sales
- shrinking profit margins
- growing operating losses
- falling credit ratings
- rapidly or steadily declining stock price, often by 75% or more from highs
- widening spreads on bonds and/or deep discounting in bond prices compared to same-maturity Treasuries
- lack of or delays in producing certified financial statements
- media and industry commentators frequently mentioning problems at the company
Once you’ve understood how a company got into trouble, the next step is to evaluate whether it can get out of trouble. In our next note of this series, we will explore some traits that indicate whether a distressed company will recover.