While the common stock of a turnaround candidate usually has the greatest upside potential, other classes of securities, such as bonds or preferred stock, may offer attractive profit possibilities with less risk.
The common stock carries the greatest risk, as it can only receive cash after all debt and other obligations are paid in full. If there is inadequate cash, the equity holder could receive nothing. But once all the other obligations are taken care of, the equity holder has rights to all remaining cash flows. In a successful turnaround, these remaining cash flows can be enormous.
Preferred stocks have a higher priority claim on cash flows than common stocks, but their claims are capped at the stated dividend amount. The most interesting preferred stocks have “cumulative” dividends that are unpaid, or “in arrears.” Cumulative preferred stocks require companies to pay all unpaid preferred dividends before common shareholders get any dividends.
For companies that have skipped preferred dividends for an extended period, the accumulated in-arrears dividends can be substantial. As the company begins to recover, investors realize that preferred stock holders might soon receive a large payment of accumulated dividends, and they bid up the price of the preferred stock accordingly.
Bonds share some traits with preferred stocks, yet have important differences. Bonds are senior to preferred stocks so they are paid first. Most importantly, interest on bonds must be paid, so companies will do everything in their power to meet that obligation. When investors aggressively sell bonds, pushing the price down, the yields can increase sharply.
For example, a bond with a 4% coupon pays $4 in interest for every $100 of bonds. If the bond price falls to $40 (perhaps investors fear that the bonds will not be paid), the company must still pay the $4 coupon. The $4 coupon on the $40 price creates a 10% current yield. If investor confidence recovers, and the bond’s price increases back to $80, the investor gets a 100% return on the bond plus all the interim $4 coupons.
Occasionally, a turnaround company will issue bonds or preferred stock that are convertible into common stock. If the conversion price is not too far above the current stock price, these securities can offer many of the protections of bonds and preferred stock yet with the upside potential of common stock. Legacy convertibles (those issued well in advance of the company’s current troubles) usually offer little improvement in value over straight bonds or preferred stock, as the conversion price is too far above the current stock price.
Another time that convertible securities can be attractive is soon after a company emerges from bankruptcy. Companies frequently issue convertibles as part of their reorganization or in a new round of financing. With the “taint” of the bankruptcy restraining demand, the interest rate or dividend rate on these convertibles tends to be high and the premium for convertibility tends to be low. Investors can get almost all of the upside potential of the common stock with a bonus of substantial interest or dividend payments.
Many turnaround companies have only one class of securities available to investors but where there are different classes to choose from, it can pay to do a little extra analysis of the various options.
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