Distressed Asset Investing: Your Ultimate Investment Guide
Get full access to our VIP Newsletter right now, for FREE. Click Here.
Why would anyone want to buy anything that is distressed let alone distressed assets?
The idea of buying something that is distressed puts most investors off, which is why so much opportunity exists in this little pocket of the market.
Buying beaten down assets in the stock market of course means buying beaten down companies well below net asset value (NAV). These assets have often been punished for good reasons, so it seems sensible to avoid them, right?
Actually, buying distressed assets can offer amazing returns if done well.
To show you how, we will run through exactly what distressed assets are, why on earth you would buy them, some famous distressed asset investors, as well as some tactics to help avoid bankruptcies. Read on!
What Are Distressed Assets?
Before getting too far, this type of investing is not without risk and should only be pursued when you know what you are doing. Having said that, fortunes can and have been made with distressed asset investing – more on that later.
So what exactly are distressed assets?
Distressed asset investing refers to the practice of buying troubled companies with significant net asset value. These companies often have major financial difficulties, and tend to be in default, or are close to it. As a result, the company’s shares typically become enormously devalued in the market. If an investor believes that the company’s problems can be overcome, these stocks can represent major buying opportunities. It’s not uncommon to see these stocks return 10 or even 20x when the company pulls itself out of the grave, and starts producing decent profits.
This type of investing is in sharp contrast to buying quality companies. WD-40, for example, is a high return on capital business with no real competition and pays a progressive dividend. As such, it would be considered a ‘safe’ low-risk investment.
Distressed companies are not pretty or considered safe and for good reason. They are companies with problems that investors are scared to hold, and sell at any price to get away from. But there are numerous examples of just how successful distressed asset investing can be when it’s done right.
Two Distressed Asset Investment Examples: Tenneco and Federal-Mogul
Charlie Munger’s investment in Tenneco and Carl Ichan’s investment in Federal-Mogul are just two great success stories that highlight just how profitable such investing can be. Both companies had falling earnings, were highly leveraged, and cast out by Wall Street. As a result of the former, both companies were at risk of bankruptcy and, on the surface, did not look like ideal investment opportunities.
As it turns out, both investments helped to make each man a fortune. Well….more of a fortune.
With Tenneco, both the debt and equity had fallen into distressed asset territory. The stock was selling for $2 a share having fallen from $10 two years previously and the debt was selling for 40 cents on the dollar. Munger brought both. Earnings had fallen from $395 million in 1997 to $91 million in 2001 with a debt level of $1.6 billion, investors were running scared.
The investment was a no-brainer for Munger. If the company went into Chapter 11 the stock would be worthless and the debt would not be paid out in full, but he would still be paid given how cheap the price was. It can be the case with distressed investing if the price is very cheap, even if things from the company turn out poorly, you can still get out with your money intact or even a profit. If however, the company could restructure and return to some sort of profitability, the stock would bounce back to intrinsic value and provide a great upside.
Whilst Buffett and Munger share a similar view “turnarounds seldom turn,” the odds on the bet in this instance were vastly in Munger’s favor.
Mr. Munger’s distressed asset investment in Tenneco resulted in around $80 Million in profits which he famously gave to Li Lu who turned this into $400 million for the Munger family. For a more detailed analysis of the Tenneco investment click here.
Distressed asset investing evidently can be extremely profitable and a worthwhile approach for the knowledgeable investor. Keep reading to gain further knowledge and insight into this strategy.
Why Buy Distressed Assets?
If given the choice, most investors would probably choose to invest in large-cap, quality businesses or an index fund and look to avoid the type of troubled assets we have been discussing.
Doing this type of large-cap investing has been shown to return 8-10% annually. This would mean every 7.2 years or thereabouts, your money would double, which if you have vast sums of money to invest might be acceptable. However, if you are looking to build wealth, you are going to need a higher rate of return and distressed (or near-distressed) asset investing is the way to achieve it.
What are near-distressed assets? Quite simply companies that are trading at distressed prices, but without the debt burden putting their futures in danger. These sorts of investments are often referred to as “deep value” since they’re offered up at deep discounts to fair value -- a.k.a. distressed prices.
Three Great Deep Value Strategies: Net Nets, Negative Enterprise Value, and Low Price to Net Tangible Asset Value
There are several different types of distressed asset investments or deep value strategies you can choose from, each of which has produced market-beating returns over the long term.
Let’s start with net-nets, Benjamin Graham’s favored approach to investing. Net nets are low price to book stocks which have had all of the long term assets stripped out of the formula. The result turns book value into what is called net current asset value (NCAV). By only focusing on NCAV the investor is valuing the company on a highly conservative estimate of liquidation value. The formula is as follows:
Current Assets - Total liabilities (Including Off-Balance Sheet Liabilities) - Preferred Shares = NCAV
The lower the ratio of Price to NCAV the cheaper the stock and generally the better the investment and returns.
To find the price ratio take the Market Capitalization and divide it by the NCAV. For example, the Market Capitalization of the company is $50 Million and the firm’s NCAV is $100 Million, the company would be trading at a 50% discount to NCAV and much cheaper than if the Market Capitalization was $75 Million with only a 25% discount. The bigger the discount the better all else being equal.
Investing with an NCAV strategy has been shown in both academic research and in practice to return 25-30% annually over the long term. A 30% return will mean your money will double roughly every 2.5 years, a much better chance at building wealth. To find out more about a net net strategy click here.
An alternative but equally attractive distressed asset strategy is negative enterprise value. The enterprise value is a measure of a company’s total value, it takes the market capitalization of the company, adds the total debt, and takes away the cash on the balance sheet. A negative enterprise value is achieved when the cash on hand is significant enough to outweigh the total debt and market capitalization, you could buy the entire company for free and have cash left over.
Let’s work through an example to cement the concept.
Company XYZ has a market capitalization of $100 Million and total debt of $50 Million with $200 Million of cash built up on the balance sheet. The enterprise value of Company XYZ would therefore equal -$50 Million. Investing in such companies has been shown to return about 27% compounded annually.
Negative enterprise value stocks occur when problems with the company arise, as is the case typically with distressed assets. If you are lucky, you can sometimes find good profitable companies trading at a negative enterprise value multiple. We here at Net Net Hunter tend to find a lot of these anomalies in Japan. Even if there are major business problems, there are several ways in which the investor can profit: the business can recover, investors recognize the price inefficiency, a third party takes over occurs, or the business liquidates. When any of these events take place the stock price of the company is likely to recover and we can take the opportunity to lock in any gains and exit profitably.
Unfortunately, it is not always the case that this type of investing works out. In the case of net nets, James Montier found that 5% of them suffer a 90% or greater loss, as opposed to 2% for stocks generally. As such, it is important to have adequate diversification in a distressed asset portfolio, 20 companies is usually appropriate as not all situations will work out.
On the other hand, as mentioned, when they do then they can show spectacular returns. Sometimes troubled companies are able to recover so well that they turn into growth stocks. This was the case with two of the companies suggested by the Net Net Hunter newsletter, Creighton’s PLC, and TransWorld Entertainment.
Creighton’s is a British consumer goods manufacturer. In 2013 the company was trading at one-third of its liquidation value and a P/E of just 4.5x, as a result of falling earnings and a tough market environment.
At the time, the firm produced small ticket, reusable, personal items operating in a defensive industry -- soap, shaving, and hair products. The company had a rock-solid balance sheet and a CEO who owned a large chunk of the business. Both of which are great positive indicators for distressed asset investing.
The company took four years to reach the market P/E ratio of 22.25x, and had grown in the meantime, producing a total return of 640%, for an annualized compound return of 65%! Creighton had managed to overcome its temporary problem and had moved into growth territory. A couple years later it was a 10 bagger.
Similarly, Trans World Entertainment faced a difficult situation. It was slow initially to adapt to the digital marketplace and the results suffered. The stock has cratered for its 2005 high of $15 to 60 cents in 2010. This was a small unloved company with a decent balance sheet with large insider ownership of 41%. Trans World managed to recover in around three years. If you had bought at 60 cents and sold at $5 three years later, this would have resulted in a 700% return.
These are only a few examples and positive ones at that, it is not always the case, but the good news is 70 to 80% of net nets seem to work out over the long term. As is the case with each of the distressed assets approaches discussed, it is best to know what you are doing and to understand the risks involved. To help get started click here.
“Distressed investing is perhaps the purest form of value investing”- J. Ezra Merkin, Introduction to Part III Security Analysis 6th edition
Famous Distressed Stock Investors
There are several famous distressed asset investors that you should pay attention to for inspiration and guidance on this type of investing. We will cover just a few.
Benjamin Graham: Distressed Assets is Where It's At
Benjamin Graham is widely known as the father of value investing and was fundamental in the success of many later value investors such as Warren Buffett and Walter Schloss.
Graham graduated from Columbia University in 1914 and had not yet found his approach to investing. Unfortunately, as a result he lost most of his money in the great depression. This experience taught Graham the hard way to focus on the downside risk by only investing in companies that were trading at a substantial discount to their fair value. He later went on to write two pivotal works, Security Analysis and The Intelligent Investor, some of Warren Buffett’s favorite books.
"[Our net net stocks strategy] gave such good results for us over a forty-year period of decision making that we eventually renounced all other common-stock choices based on the regular common stock procedures, and concentrated on these ‘sub-asset stocks.’ "- Ben Graham, [The Decade 1965-1974; Its Significance For Financial Analysts, Benjamin Graham, 1975.]
Peter Cundill: The Canadian Benjamin Graham
Peter Cundill is another example of a masterful distressed asset investor. Cundill was a Canadian born investor whose distressed asset fund return 26% compounded annually over its first ten years.
His investment strategy was simple in that he focused on finding companies that were trading at a discount to their liquidation value and at other suitable value metrics. This type of strategy requires a great deal of patience, conviction, and the right temperament but the returns as we have discussed are excellent.
Cundill is quoted as saying "being out on a limb, alone and appearing to be wrong is just part of being a value investor." With a distressed asset portfolio, you are likely to appear wrong for prolonged periods of time but that’s one of the joys of being an outsider. That and the impressive returns.
"You find bargains among the unpopular things, the things that everybody hates."- Peter Cundill
Eddy Lampert: The Best Distressed Investor of His Generation
Last but by no means least, Edward Lampert, the current CEO of Sears and fellow distressed asset investor. Lampert was born and raised in New York and started his investment career by analyzing the stock picks that his Grandmother made each week. After graduating summa cum laude from Yale he interned at Goldman Sachs in the risk arbitrage department. After a brief three year stint, he founded ELS Investments in 1988. Lampert went on to make his investors 25% returns annually since the inception of his fund.
The fund runs a concentrated portfolio of between 3-15 companies and is event-driven when picking stocks. This means that the fund hunts for companies that are distressed and are trading for less than fair or intrinsic value. A prime example of this was his investment in Kmart’s debt while the company was in Chapter 11 bankruptcy protection. Lampert eventually took control of the company and the shares skyrocketed from $15 a share to $150 two years later. His net worth has recently taken a bit of a dip from $3 Billion to around $1.2 Billion due to the continued issues with his Sears Holdings. As you already know, some of the time distressed asset investing underperforms.
"If you're unwilling to try new things and to fail and learn, you don't have a shot. That doesn't mean you are going to be successful, but you have to try to change."- Eddie Lampert
Tactics To Avoid Bankruptcies and Large Drawdowns
As alluded to early, there are several characteristics that investors should look for when investing in distressed assets. These characteristics will help to avoid bankruptcies, loss of capital, and increase the chances of profitable returns.
It is best with distressed asset investing as it is with any complex process to have a system in place to minimize mistakes. The process can be further broken down into an initial quantitative set of core criteria with a secondary qualitative set of criteria to strengthen the portfolio. This is exactly what we've done in our Net Net Hunter Scorecard.
The basic quantitative measures for a net net checklist have been formed through both academic research and practice but should include such criteria as a suitable average daily volume; price to NCAV below 100%; market capitalization below $100 Million; market capitalization above $1 Million; no significant Chinese operations; not selling shares; current ratio above 1.5x and a debt to equity below 50%. Each has been shown to help minimize poor investments and reduce bankruptcy risks.
The quantitative measures provide a focus on criteria that statistically boost return whilst the qualitative measures are the icing on the cake that really help to strengthen the investments. Such criteria include a catalyst; high-quality growth; significant past earnings; past price above NCAV; an activist investor, insider ownership, and insider buying or share buybacks.
For a full breakdown and rationale of the Net Net Hunter Core Criteria click here.
Where to Find Distressed Assets?
I know what you're thinking… this all sounds great but how do I go about finding such investment opportunities? And, what’s the catch?
Well, the catch is this strategy doesn’t work all of the time, and there can be long periods of underperformance. You must look to the long term to really see the great opportunities on offer and the beauty of the distressed asset strategy.
There are several great resources that will help you find these types of investment opportunities. One such place is right here on Net Net Hunter, which focuses on (drum roll) net nets. By joining Net Net Hunter, you get direct access to all of the information that has been gathered on how to invest using Graham's favorite strategy, but more importantly a community of skilled net net investors and both a bulk list of global net nets and a refined short list of the best opportunities available. Of Course, there's also a lot available for free in terms of articles and on our Net Net Hunter VIP Newsletter if you just want to read about net nets.
Another resource for finding good distressed opportunities is a stock screener. There are free screeners available for net nets but these often lack the functionality needed to undercover the better picks. You also need to be prepared to spend 30+ hours per month hand filtering global net nets to arrive at a small pool of high quality opportunities to research. Software is not a solution, unfortunately, due to data issues with tiny companies. We've gotten the process down to about 20 hours a month, but we've also been doing it since 2010.
Screens are probably more helpful in identifying larger firms that fit other sort of distressed strategies. Your returns will drop, however, as firm size grows.
Finally, whilst it is a bit old school nowadays, newspapers or investment magazines can also be a good resource. Charlie Munger read Baron’s Magazine for 40 years and only found one investment opportunity, it just so happens this idea resulted in a $400 Million addition to his fortune.
If you’re a small private investor and want to start building your net net portfolio, it’d be worth your while to download Your Essential Guide to Net Net Investing, with more tips to stock your portfolio with the highest quality net nets worldwide.
Start putting together your high quality, high potential, net net stock strategy. Click here to get the free net net stock checklist.