Understanding financially distressed and bankrupt companies.

Financially distressed and bankrupt securities are analytically complex and often illiquid.

The reorganization process is both tedious and highly uncertain. 

Although the number of variables is high in any type of investing, the issues that must be considered when investing in the securities of financially distressed or bankrupt companies are greater in number and in complexity. 

In addition to comparing price to value as one would for any investment, investors in financially distressed securities must consider, among other things, 

• - the effect of financial distress on business results; 
• - the availability of cash to meet upcoming debt-service requirements; and 
• - likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them. 

Similarly, investors in bankrupt securities must develop a thorough understanding of the 

• -  reorganization process in general as well as 
• -  the specifics of each situation being analyzed.

Financially Distressed and Bankrupt Businesses

Companies get into financial trouble for at least one of three reasons: 

• - operating problems, 
• - legal problems, and/or 
• - financial problems. 

A serious business deterioration can cause continuing operating losses and ultimately financial distress.

Unusually severe legal problems caused tremendous financial uncertainty for these companies, leading them ultimately to seek bankruptcy court protection. 

Financial distress sometimes results almost entirely from the burdens of excessive debt; many of the junk-bond issuers of the 1980s shared this experience.

Financial distress is typically characterized by a shortfall of cash to meet operating needs and scheduled debt-service obligations. 

• -  When a company runs short of cash, its near-term liabilities, such as commercial paper or bank debt, may not be refinanceable at maturity. 
• -  Suppliers, fearing that they may not be paid, curtail or cease shipments or demand cash on delivery, exacerbating the debtor’s woes. 
• -  Customers dependent on an ongoing business relationship may stop buying. 
• -  Employees may abandon ship for more secure or less stressful jobs.

Effect of financial distress vary from company to company

Since the effect of financial distress on business results can vary from company to company, investors must exercise considerable caution in analyzing distressed securities. 

The operations of 

• capital-intensive businesses are, over the long run, relatively immune from financial distress, while 
• those that depend on public trust, like financial institutions, or on image, like retailers, may be damaged irreversibly. 

For some businesses the decline in operating results is limited to the period of financial distress. 

• -  After a successful exchange offer, an injection of fresh capital, or a bankruptcy reorganization, these businesses recover to their historic levels of profitability. 
• -  Others, however, remain shadows of their former selves.  

The capital structure of a business also affects the degree to which operations are impacted by financial distress. 

• -  For debtors with most or all of their obligations at a holding company one or more levels removed from the company’s primary assets, the impact of financial distress can be minimal. Overleveraged holding companies, for example, can file for bankruptcy protection while their viable subsidiaries continue to operate unimpaired; Texaco entered bankruptcy while most of its subsidiaries did not file for court protection. 
• -  Companies that incur debt at the operating-subsidiary level may face greater dislocations.

More often bankrupt enterprise continues in business under protection for some to return to financial health

The popular media image of a bankrupt company is a rusting hulk of a factory viewed from beyond a padlocked gate. Although this is sometimes the unfortunate reality, far more often the bankrupt enterprise continues in business under court protection from its creditors. 

Indeed, while there may be a need to rebuild damaged relationships, a company that files for bankruptcy has usually reached rock bottom and in many cases soon begins to recover. 

• -  As soon as new lenders can be assured of their senior creditor position, debtor-in-possession financing becomes available, providing cash to meet payroll, to restock depleted inventories, and to give confidence both to customers and suppliers. 
• - Since postpetition suppliers to the debtor have a senior claim to unsecured prepetition creditors, most suppliers renew shipments. 
• -  As restocked inventories and increased confidence stimulate business and as deferred maintenance and delayed capital expenditures are undertaken, results may begin to improve. 
• - Cash usually starts to build (for a number of reasons). 
• -  When necessary, new management can be attracted by the prospect of a stable and improving business situation and by the lure of low-priced stock or options in the reorganized company. 

While Chapter 11 is not a panacea, bankruptcy can provide a sheltered opportunity for some troubled businesses to return to financial health.

The Value Investing Process: Investing in Financially Distressed and Bankrupt Securities

As we have learned from the history of the junk-bond market, investors have traditionally attached a stigma to the securities of financially distressed companies, perceiving them as highly risky and therefore imprudent. 

Financially distressed and bankrupt securities are analytically complex and often illiquid.

• The reorganization process is both tedious and highly uncertain. 
• Identifying attractive opportunities requires painstaking analysis; investors may evaluate dozens of situations to uncover a single worthwhile opportunity. 

Although the number of variables is high in any type of investing, the issues that must be considered when investing in the securities of financially distressed or bankrupt companies are greater in number and in complexity.

• In addition to comparing price to value as one would for any investment, investors in financially distressed securities must consider, among other things, the effect of financial distress on business results; the availability of cash to meet upcoming debt-service requirements; and likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them. 
• Similarly, investors in bankrupt securities must develop a thorough understanding of the reorganization process in general as well as the specifics of each situation being analyzed. 

Because most investors are unable to analyze these securities and unwilling to invest in them, the securities of financially distressed and bankrupt companies can provide attractive value investment opportunities. Unlike newly issued junk bonds, these securities sell considerably below par value where the risk/reward ratio can be attractive for knowledgeable and patient investors.

Value Investor's Opportunities in Distressed Securities

Some of the risks and opportunities associated with investing in distressed securities. 


While regular value investing involves dealing with a wide number of unknowns, distressed securities represent particularly complex situations. 

Because most investors are unwilling to put in the time and effort involved with analysing such securities; for some, the opportunities are plentiful in this realm.



Three Reasons for financial distress

There are three reasons a company might run into financial distress: 

• operating issues, 
• legal issues, and/or 
• financial issues. 

Responses to financial distress and the implications to the investment

Issuers can respond to such situations in one of three ways: 

• continue to pay obligations, 
• attempt to convert obligations into less stringent obligations (e.g. get debt holders to accept preferred stock), or 
• default and declare bankruptcy. 

Investors must understand the implications to their investments as the above scenarios play out. 

Investors must also: 

• understand how other stakeholders will react to such situations, and 
• understand the power that various stakeholders have (for example, one third of a stakeholder groups constitutes a blocking group, and can use this to further that stakeholder group's interests).

Investing Opportunities in Bankruptcies

While bankruptcies are often complex and difficult to analyse.

Investors who know what they are doing usually have tremendous opportunities for returns with very little risk. 

At the same time, someone who doesn't know what he's doing risks losing his entire investment.

The process of analysing financially distressed securities starts at the balance sheet. 

• Assets should be valued so that the size of the pie can be estimated. 
• Obligations should then be subtracted from this amount. 
• This task is much more difficult than it appears, however. 
• For a distressed company, asset values are usually a moving target, and getting a handle on their value can be difficult. 
• Furthermore, off-balance sheet liabilities must also be considered.

In bankruptcies, mis-pricing can occur which allow the enterprising value investors the opportunity for excellent returns.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Buying Stocks on the Verge of Bankruptcy

QUESTION: Why is it that investors are buying stocks in companies that are on the verge bankruptcy like AIG (AIG: 1.60, -0.07, -4.19%) and General Motors (GM: 4.49, +0.83, +22.67%)? Is there any benefit to buying at this price, and what would be the worst-case scenario of my investment?
--Mike Ghazala

ANSWER: Let's get right to the point: The worst-case scenario is you lose your entire investment. When a company files Chapter 11 the business is reorganized, but there's no guarantee shares will be worth anything once the company emerges from bankruptcy protection. Ditto for a Chapter 7 bankruptcy liquidation, in which a company's assets are sold off. Rules governing corporate bankruptcies generally dictate that secured and unsecured creditors -- banks, bondholders and the like -- get paid off first. Stockholders are last in line, and often there's nothing left by the time their turn comes around. If there are assets remaining, stockholders may receive shares in the newly reorganized company.

So why do investors buy shares of companies on the verge of bankruptcy?

Some may truly believe the company will avoid disaster and bounce back, making the shares an attractive long-term investment.

More often than not, though, investors are looking to make a quick buck on a short-term trade. In that case fundamentals are thrown out the window. Hedge funds and institutional trading desks are often involved in highly leveraged trades of these extremely volatile stocks. With such heavy hitters in the game, and so much uncertainty surrounding the companies, we recommend that individual investors keep their distance.

One other note: Even in bankruptcy a company's shares may continue to trade, often for pennies apiece. While the low price might be tempting, liquidity is spotty because the stocks are usually forced to trade over the counter rather than on a major exchange like the NYSE.



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