LEVEL: BEGINNER
The risk/reward ratio is ideally directly related, so the higher risk an investor takes on, the higher the reward. Most debts are priced along a risk curve, so that the higher the risk, the higher the percentage interest the indebtor needs to pay the creditor. When it comes to equities, the risk/reward ratio is much more complicated, because it usually involves a number of qualitative criteria that must be considered alongside quantitative criteria.
For investors looking for a high reward and who are willing to take on a high level of risk to reach that goal, distressed equities are an option. These are usually stocks which have recently suffered an extreme drop in value due to an extreme financial or business-related risk. Sometimes, the risk comes from rumors of a scandal or that the company’s practices are fundamentally unsound (recently, Herbalife–HLF–was considered a high-risk distressed asset by some because of its dubious business practices, while others called it a good value). In many cases, stocks will suffer an extreme drop in value because there are rumors that the company is near bankruptcy, and may file for Chapter 7 or Chapter 11 protection–types of legal bankruptcy processes. Since common stocks are the last in line in these situations, they often have little to no value throughout the process, which is why they often fall to a near-zero value.
A good example of an extreme drop in value in a distressed security is the Federal National Mortgage Association, or Fannie Mae (FNMA), which lost over 99% of its value by the end of 2008 as the subprime mortgage crisis rendered so many of its secured mortgages worthless. Shares went from a high over $34 per share to penny stock territory.
An investor seeing value in this government-backed company could have invested in 2009 after the crash and seen the value of the investment more than double that same year (the stock rose to $2 for a brief moment from a base of around 70 cents). This is a very high return on investment–but the risk of investing in a bankrupted company at the center of the largest financial crisis since the Great Depression is considerable. Still, investors willing to take on this risk will often incorporate them into a high-risk high-yield equity fund.
Identifying Value in Distressed Equities
There are a number of ways that investors invest in distressed equities:
1. Strong upside from a buy-side analysis: If the investor identifies that the company in question has a particular and unrealized value in a particular market, they might be willing to shoulder the risk of investing in a bankrupted or scandal-ridden company. They might still think it has the potential to make a strong recovery because of demand for a product, unique market position, or name-brand recognition. American Airline’s holding company AMR Corp. (AAMRQ) is an example of a popular distressed equity investment.
2. Technical indicators pointing to swing opportunities: Distressed equities are often much more volatile, offering a better profit potential for day traders and swing traders. Technical analysts can often capitalize on strong swings in the stock’s movement regardless of fundamentals based on a technical analysis of the stock’s momentum.
3. Capitalizing on a higher risk tolerance: In many cases, distressed equities sell for far less than they would otherwise be worth according to a fundamental analysis of the company’s book value and earnings potential. This happens often because certain funds, such as pension funds and other more conservative investment funds, will only invest in investment-grade securities (for bonds, this means a bond with a rating over BBB). If the security is considered non-investment grade, the fund is required to sell as quickly as possible, meaning time is more important than a fair price. Hedge funds often come into this equation by snapping up these distressed securities at below market value, since they do not have a mandate to invest in a certain level of security. This third strategy is often limited to bonds, but also applies to stocks as well.
When investing in a distressed security, the important calculation is not only the company’s book value, earnings potential, and future growth–which in many cases will be negative–but also the liquidation value of the security. In other words, if the company was forced by law to sell everything it owned in order to pay back debtors (who get their money first) and equity holders (who get their money last), how much would each stock be worth? Often, the market will price stocks at this level after a company has become distressed, but in many cases that valuation will be inaccurate. Investors in distressed equities identify those inaccuracies, and try to profit by buying below the true value of the stocks and waiting for the market to catch up, or, eventually, waiting for liquidation.