Many of us have seen a company declare bankruptcy. With the financial crisis of 2008, there were many companies who went under in the chaos of the market crash. However, there were also many who bounced back from their initial distress and went on to become profitable investments again. This is why investing in distressed companies is a popular idea. If you can find the right company to put money into, you can reap a great reward for your time and risk once the company rebounds.
Why Invest in Distressed Companies?
Investing in distressed companies is different than investing in penny stocks. The difference between investing in distressed companies and investing in other low-cost stocks is a matter of return. Penny stocks are stocks that are traded under the dollar mark. For the most part, they’re a gamble. Some people are capable of making good money on that market. However, it’s not as easy as it looks, and your small losses can add up to big ones if you’re not careful.
Distressed investments are usually easy to spot. They’re companies that have reached higher performance benchmarks, like the S&P 500, and have now fallen down to a very low price. This can be due to several different reasons, but usually has something to do with financial distress, such as illiquidity. Most distressed companies will have a credit rating of CCC or lower. While distressed investments usually appear to be in dire straits, the situation is sometimes not as bad as it appears, which opens the door for investors.
What Distressed Companies to Invest In
Picking which distressed companies to invest your money with isn’t always easy. Part of the risk of investing in distressed companies is that there is always a chance that the firm will go bankrupt, which will render the stock worthless. Investing in distressed companies is going to be speculative by nature, and there is a certain amount of risk that it is hard to eliminate. What you’re really looking for when you look for distressed companies is ones that you feel aren’t in as bad of a situation as the market believes they are. This is your opportunity for profit.
If you find a company that’s simply having a bad couple of months, either from financial overextension or from leadership errors, it’s worth investing, since the risk of failure is fairly low when the stock prices are so far down. It’s important that you choose companies that still have some level of consumer and creditor confidence though. There’s nothing worse than buying the stock, and then the loans being called the next day. Remember, once the company declares bankruptcy, your stock investment becomes worthless.
How Much Are Distressed Companies Worth?
Determining how much your distressed company is worth is a large part of deciding whether or not to invest. Investing in distressed companies should have a higher return than a normal investment. This is because of the amount of risk involved in the company is much larger than a normal investment. One good guideline is that the expected rate of return should exceed the return on a treasury bond by 1,000 basis points, or 10%.
You can determine the value of a distressed company, and thereby the expected value of the stock, by examining the past values of the stock before the company fell into distress. Once you see what the previously accepted value of the stock used to be, you can decide for yourself if you believe there will be enough return in the future to adequately compensate you for your risks.
How to Invest in Distressed Companies
Investing in distressed companies is as simple as purchasing the stock on the open market and holding it until one of two things happens. If the stock prices begin to rise, you should hold for as long as you can before selling for the best possible return. If the company declares bankruptcy, you should study what happened in the company to push it over the edge, and keep that information in mind the next time you buy a distressed company’s securities.
One such example of this strategy working sucessfully, is Ford Motors in 2008. In late 2008 their stock was down to $1.01, and they lost 12.7 billion dollars that year. However, Ford made the kind of comeback that most people in the market at the time couldn’t imagine. They’re currently trading at $12.01 today. An investor who bought one hundred shares of Ford Motors at $1.01 nine years ago, and sold it today at $12.01 would stand to make $1,100 in return, on a $101 dollar investment.
This is a return on investment of 10.89, which is astronomical considering most ROIs are considered good at 5. An investor who bought Ford in 2008 would have ten times the money they did in 2008. Even more impressive is the fact that their overall risk at $101 was minimal, and is a loss they could easily afford. How much money you can afford to lose is important to keep in mind when you’re buying distressed securities. It’s also important to keep in mind that change might not happen overnight. It took Ford’s stock almost three years to rebound from their distress in 2006 – 2008.
Are Distressed Companies a Good Investment?
Here are the pros and cons of distressed security investing.
You can make a lot of money. The return on distressed investments should exceed and average ROI of 5.
The risks are fairly small, since the original stock price is so low
Since the original price is so low, distressed investing is an excellent way to grow your portfolio.
Distressed investing can be a bit of a long game. Companies take time to rebound from deep financial dives. Your money could be tied up for some time.
These investments are inherently speculative. There’s a chance that the company can declare bankruptcy, rendering your investment worthless.
Having an investment that grows is great. However, you have to make sure to sell it at a high, which can be hard to anticipate.
Investing in distressed companies is one of the few ways left in the American Stock Market to exploit a knowledge gap, and therefore earn a profit. Because of the low-risk when you purchase the stocks as well as the potential for earning a very large return, distressed investing is a popular strategy for hedge funds and other investors. You can make it work for you too, though not quite on that scale.
It is important to remember that this type of investing can be speculative. The timing of selling the asset once it’s gained value again is important. Once you have your investment picked out, remember that it can be a bit of a long game before the value increases again. Therefore, you’ll have to pay good attention to the markets to know when to sell.