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Investing in distressed securities can produce outsized gains, but also involves more risk than investing in traditional securities. In our final note in the series, The Turnaround Letter steps away from the mechanics and analytics to share some thoughts on how to handle the emotions involved, when to exit and the role of distressed securities in your portfolio. We’ll wrap it up with a quick review of the series.
- Ignore price volatility, focus on understanding the security and the likely outcomes, and be patient.
- Exit when the security recovers or reaches a price target, or when the company’s fortunes take a major turn for the worse. In some cases, holding until after the emergence from bankruptcy makes a lot of sense.
- Distressed securities should be part of a diversified investing program matched to your constraints.
- Summary of the basic elements of successful investing in distressed securities.
As the range of potential outcomes for a distressed security is wide, the path to the endgame is uncertain and the timing can be protracted, it is easy to let your emotions drive your strategy. Once you’ve made the decision to invest, the waiting--doing nothing--is the most difficult part.
The best way to handle the ride is to understand the distressed situation, map out the likely outcomes and monitor the progress. As time passes, assess which outcomes increase in likelihood, and which ones decrease. Have the patience to stay with a recovery that makes progress. Ignore Wall Street’s quarterly guessing game about beating or missing earnings estimates--analysts often assume unrealistic linear paths to recovery.
Short-term speculators can produce a highly volatile security price--driving it up on good news and crushing it on bad news. So an aggressive short-term trading strategy is not well-suited for success as it is too easy to buy at the top and sell at the bottom. The best approach is to maintain your position with a long-term perspective. Perhaps the worst strategy is becoming impatient and selling a promising security early, at a loss or a small gain, leaving potentially substantial longer-term gains on the table.
You can choose which of several exit points most appropriately suit your risk/return preference for each distressed security investment:
- When the security price recovers to nearly full value or reaches a pre-determined price target.
- When the fundamentals of the company take a major turn for the worse, often making a bankruptcy filing imminent. Selling may preserve more value than waiting for the eventual filing.
- When the company files for bankruptcy. Equities generally become worthless in a bankruptcy, so holders usually sell immediately upon the filing to preserve any remaining value. A bond investor with no specialized expertise or inclination to hold distressed securities during bankruptcy might exit upon filing.
- After emergence from bankruptcy. Bond holders may receive meaningful post-bankruptcy value in a number of ways: payment in full in cash, partial payment in cash, payment in new post-bankruptcy equity or other new securities or some combination of these. When a company is about to emerge from bankruptcy, the old bonds may convert into the new stock at a bargain price.
Because distressed securities are volatile, carry substantial risks and may take time to reach their potential, they should not be the only approach to your investing. Rather, they should be a part of a diversified investing program matched to your risk tolerance, liquidity needs, time horizon and other investing constraints.
As our series draws to a close, some of the basic elements of successful investing in distressed securities to remember include the following:
- Distressed companies are fighting the clock. This elevated risk turns off most investors, creating inefficient pricing that can produce outsized returns to investors who can successfully navigate distressed securities. Gains of 100-200% are not uncommon. Given the risk, most investors in distressed securities focus on bonds.
- You can find distressed securities through low-cost or free sources like web-based screening tools, holdings of ETFs and mutual funds that specialize in distressed securities, various news sources, investment publications and social media apps and websites.
- The ultimate goal in evaluating a distressed security is answering this question: is there anything here worth investing in? Understand why the company is distressed--dig through the symptoms to find the underlying causes. At the heart of distress is change. The most common causes of distress are poor management and dishonest management.
- The best indicator of whether a company will recover is the management’s willingness and speed in dealing directly with its distressed situation. To get out of trouble, the company must find cash (to buy time) and improve the value of its assets. Fixing its core operations usually requires new management and a credible plan.
- To evaluate the potential payoff, determine what the company could be worth if it recovers, then parse out the value between the debt and equity. Enterprise value/Ebitda on a post-recovery basis is generally a more effective valuation method than traditional metrics like price/earnings and price/book ratios or dividend yields.
- Using relatively straightforward math you can map the likely outcomes of most distressed investments.
While investing in a company struggling to survive may not appear to be a sound strategy, for investors willing to learn about the opportunities, and understand and accept the risks, investing in distressed securities can produce outsized returns.