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2 Distressed Companies to Avoid

Buying stock of distressed companies is more of a gamble than an investment, and these two struggling retailers are best avoided.

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At the deep end of turnaround investing is distressed investing. Buying stocks of distressed companies can produce stunning returns, perhaps 500%, or 5x, an initial investment, or more. Potential returns of this magnitude can seem very appealing to investors.

A company can be called distressed when it currently has difficulties meeting its debt and other financial obligations. Its bonds may have credit ratings of CCC or lower – well into the junk category – and trade at yields that are 10 percentage points or more above U.S. Treasury bonds of the same maturity. Stocks of distressed companies may trade close to zero as most investors, particularly professional money managers, have abandoned the shares. The risk, of course, is that these stocks go to zero as the companies slide into bankruptcy.

In recent years, with the surging economy and plenty of readily available, exceptionally cheap capital, the pool of distressed stocks and corporate bankruptcies has been unusually shallow. The collapse in oil prices starting in mid-2014 spawned a modest jump in the number of distressed energy company failures, and the Covid pandemic produced a few notable failures like Hertz (and most recently Revlon and Armstrong Flooring), but the pace is nothing like the surge following the global financial crisis.

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When does it make sense to invest in the shares of distressed companies? In short – almost never. Once a company becomes so financially strained that it is unlikely to meet its bond payments without a miracle, its shares become a gamble rather than an investment. Further, holders of distressed bonds are very savvy about protecting their interests through a variety of legal and other tactics that aren’t necessarily shareholder-friendly. The odds of a distressed company successfully extracting itself from an eventual bankruptcy are very low, perhaps only 5%. With a one in twenty chance of success, that 500% profit potential is not worth the 95% chance of a complete loss.

2 Distressed RetailersOne of the more fascinating distressed situations today is Bed, Bath and Beyond (BBBY). This former leading retailer of household goods struggled for well over a decade with consumers’ transition to the internet. The shares have collapsed to around 5 from 25 earlier this year and from as high as 80 in early 2014. An aggressive activist campaign that replaced the CEO and restructure the board of directors in early 2019 brought hopes of a turnaround.

One of the keys to successful retailing is to stock products that people actually want to buy. However, Bed Bath’s new leadership emphasized generic store brands that turned off their primary customer – bargain hunters looking for nationally recognized brands. And, confirmed by our on-site due diligence, the stores today are definitely neat and organized compared to the jam-packed disorganized jumble of the past, but the merchandise and store environment is now sparse and uninspiring. The company’s dismal first-quarter update led to the ouster of the CEO and other senior management. This fresh attempt at a turnaround appears unlikely to succeed – Bed Bath’s profit potential appears grim, liquidity is thin and the balance sheet is overburdened with debt and other obligations. Its buybuy Baby franchise may hold some value, but that value may end up in bondholders’ hands. For now, this is a stock to avoid.

Another intriguing retail stock is Wayfair (W). Its shares have tumbled 85% from their post-pandemic high and now trade at about twice the 29/share price at its 2014 IPO. Favorably, the balance sheet carries nearly $2 billion in cash and equivalents. Yet, outside of the pandemic-driven surge that produced a sizeable profit, Wayfair remains a structurally unprofitable company and thus has limited economic value. The co-founder/leadership continues their expensive and aggressive pursuit of market share and emphasizes Wayfair’s value to its suppliers and customers (although its weak reputation among shoppers may belie this), but shareholders and profits are an afterthought at best. Wayfair isn’t yet distressed, but its thirst for fresh cash to fund its losses, and its $575 million in debt that comes due in two years, relies on a degree of generosity from the capital markets that may no longer exist. Wayfair shares are currently uninteresting. Some companies’ shares trade at healthy prices even if they may have zero underlying value.

Our strategy emphasizes turnarounds of companies that offer real value whose shares are out of favor. We generally avoid companies that are poised for bankruptcy and almost never invest in shares of bankrupt companies (the shares are almost always worthless even if they trade at positive prices). However, we are much more interested in companies after they have emerged from bankruptcy. These post-bankruptcy companies have greatly reduced debt burdens and new leadership who may be able to restore the company’s prosperity. As the bankruptcy pool is likely to re-fill over the next few years, we see real opportunity.

At the Cabot Turnaround Letter and Cabot Undervalued Stocks Advisor, we help investors navigate the equity markets using a commonsense, value-oriented approach that emphasizes out-of-favor stocks of companies with real value. Let us help you sort through the market to find them.

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Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.