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What is Distressed Investing?
In simple terms, a distressed company is one showing one or several tell-tale signs of financial strain. Investing in distressed securities means purchasing the equity and fixed income securities of companies that are either in bankruptcy or have a meaningful likelihood of filing for bankruptcy in the near future. These companies have claims against them that are greater than the value of their assets. More concretely, distressed companies don't have the cash flow to service their debts.
As others clamor for the exit, contrarian investors look for potential investment opportunity.
Critical to the definition of "distressed": These companies are fighting the clock—if operating results don't improve soon or if their debts are not renegotiated, a bankruptcy will likely result. Their survival, in essence, is on the line. So how is this different from "turnaround investing"?
Generally, investors in distressed securities want a turnaround—that is, they want the company to become operationally and financially stronger which will drive up the value of the (formerly) distressed equities and bonds. When we at The Turnaround Letter think about "turnarounds" we think about companies that are not fighting the clock. Rather, turnaround companies in our view have the financial staying power to provide them the time to make major improvements to their operations.
Distressed investing usually involves greater risk than turnaround investing, but can also offer higher returns.
While distressed securities are higher risk, they also offer the potential for outsized gains. I've been investing in distressed stocks and bonds for 30 years now, and here's a quick overview of what I've learned during that time:
- The elevated risk of distressed securities turns off most investors, creating inefficient pricing that can produce outsized returns to investors who can successfully navigate distressed securities.
- You can find distressed securities through low-cost or free sources.
- The ultimate goal in evaluating a distressed security is answering this question: Is there anything here worth investing in?
- 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.
- Fixing a company’s distressed 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.
Given the risk, most investors in distressed securities focus on bonds. These securities can provide greater downside protection than equities, as they may have legal claims on valuable assets and may receive new securities or cash in a bankruptcy reorganization. Yet they still can provide significant upside potential, as gains of 100 to 200% are not uncommon. Distressed equities could potentially provide returns measured in multiples, yet if the company restructures or files for bankruptcy the equity generally becomes worthless.
Spotting a distressed company is the relatively easy part, but what should you do with that information?
When a company is experiencing financial distress, its stocks, bonds and other securities typically experience a significant price drop. This sharp decline happens because most investors, including many “sophisticated” institutions, are afraid of turnaround situations. In their haste to unload distressed securities, shareholders often fail to consider their valuation and other indicators that will reveal a company’s true potential and future prospects. This panic often causes investors to sell too quickly.
Contrarian investors knows that when the herd bails out, that is often the perfect time to buy in.
Due to their reduction in value, distressed securities present a unique opportunity for savvy investors to buy in at bargain prices. You'll see a long-term history of market beating results from our closed-out purchase recommendations. Now, take a look at the results distressed investing can offer. This list reflects just a few of the Turnaround Letter purchase recommendations that have realized a return rate of 200% or better:
“The only thing more expensive than education is ignorance.”
- Benjamin Franklin
Obviously, not every distressed investing situation is going to result in this kind of profit. Some will liquidate or be acquired, while others can languish with depressed stock prices for years. Like all stock market activity, contrarian investing comes with a certain degree of risk. That's why you need trustworthy advice, and George Putnam’s prudent investment strategy has minimized those risks and maximized financial reward for the past three decades. The Turnaround Letter has the longevity and proven track record to help you lock in distressed investing profit.