It’s frightening…It’s difficult…It’s harrowing…and
it’s very, very profitable.
I’m talking about "distressed investing," also known as
"vulture investing." It is the ultimate expression of
contrarian investing. It requires buying the stocks or
bonds of companies that are in deep financial distress,
often in bankruptcy, with the expectation that they will
emerge from bankruptcy a new and improved and – debt-free –
The recent Kmart saga provides a text-book example.
Once a giant among retailers, Kmart struggled for decades
to compete with the likes of its more agile competitors,
namely Wal-Mart and Target. Years of futility finally
brought the old retailing icon to its knees. In January
2002, Kmart became the largest retailer ever to file for
Left for dead by most investors, a few savvy money managers
detected signs of life within the comatose retailer. Martin
Whitman, manager of the Third Avenue Value Fund, was one of
them. Whitman has a long history of investing in distressed
companies, going back to the 1970s. In the 1980s, he found
a pot of gold in the bankrupt securities of Anglo Energy
(now Nabors Industries). Whitman’s cost basis in Nabors is
around 40 cents on a stock that today trades north of $60!
So what did Whitman see in Kmart? For one thing, he saw a
company with $25 billion in revenues selling in the market
for about $1 billion. Plus, Kmart owned a lot of real
estate. So the risk of loss, he estimated, was low and the
potential profit was enormous.
He bought some of the company’s debt for pennies on the
dollar…No other Kmart shopper has ever walked away with
such a bargain.
Eventually, Kmart emerged from bankruptcy. Much of the debt
converted to new stock, leaving the new post-bankruptcy
Kmart free of its heavy debt load. Not long after emerging
from bankruptcy, Kmart and Sears agreed to merge, creating
Whitman made a 13-fold return on his Kmart investment in
about three years!
Investing in distressed situations is analytically complex.
The securities are usually illiquid and the process itself
is highly uncertain and tedious. Few investors are willing,
and even fewer are capable enough, to dredge through the
muck…Therein lies the opportunity.
Seth Klarman, the astute and successful investor behind the
Baupost Group, covers investing in financially distressed
and bankrupt companies in his book, "Margin of Safety."
"The popular media image of a bankrupt company is a rusting
hulk of a factory viewed from beyond a padlocked gate," he
writes. "Although this is sometimes the unfortunate
reality, far more often the bankrupt enterprise continues
in business under court protection from its creditors… a
company that files for bankruptcy has usually reached rock
bottom and in many cases begins to recover."
The shelter of bankruptcy allows a company to get back into
financial health. Once in bankruptcy, companies can void
leases, nullify long-term contracts and even terminate
prior labor agreements. Prior debts are restructured or
swapped for new stock in the reorganized company. The new
post-bankruptcy company frequently emerges as a low-cost
competitor, since it has shed many of its prior high-cost
commitments. (Imagine how strong your personal balance
sheet would look if you could simply erase all the numbers
on the liability side of the ledger!)
Plus, bankrupt companies frequently build up cash — another
source of value. Bankrupt companies also usually have
substantial net operating losses carryforwards, or NOLs,
which result from prior losses. NOLs can be used to offset
future taxable income — a valuable asset in any market.
As Klarman notes, "When properly implemented, troubled-
company investing may entail less risk than traditional
investing, yet offer significantly higher returns." Yet all
is not cakes and ale. When done poorly, as with any
investment strategy, the results can lead to disastrous
losses. That’s why, in the latest issue of the Fleet Street
Letter, I recommended a publicly traded company that excels
at vulture investing. The guys that run this company are
some of the best in the business.
One very unique virtue of vulture investing is that it
tends to excel during times of financial trouble. In this
sense it is countercyclical.
The ’70s recession, for example, created opportunities in
real estate, particularly in distressed real estate
investment trusts (REITS). In the 1980s, the vultures found
fresh carrion in the remnants of the junk bond meltdown and
nasty downturns in energy and steel that created a new crop
of corporate wounded.
The U.S. economy will continuously produce distressed
companies, like a pride of lions produces gazelle
carcasses. As long as there are mistakes, recessions,
bubbles and busts, there will be tasty corporate carrion
for vulture investors.
The company I recommended to my Fleet Street subscribers
relies on a handful of investment principles, which stitch
together the apparently unrelated investments that make up
its portfolio. These principles are often repeated in the
company’s annual letters (I’ve read them all going back to
1998). Here they are:
1. Don’t overpay
2. Buy companies that make products and services that
people need and want and provide them as cheaply as
possible with consistently high quality. Search out
candidates in out-of-favor industries that have
turnaround potential. Our record as midwives to
resuscitating disorganized, unprofitable, bedridden
and moribund companies is pretty good
3. Earnings sheltered by net operating loss
carryforwards (NOLs) are more valuable than earnings
that are taxed by the IRS
4. Pay employees for performance and expect hard work
and honesty in return
5. Don’t overpay.
To the list above, I would like to add one more rule: Don’t
Did You Notice…?
By Chris Mayer
In my CrisisPoint Trader, I’ve done a little "vulturing" of
my own. In the current market environment, there are a
number of cash-rich, bombed-out technology companies.
I’ve found one of these situations in Sycamore Networks
(SCMRE: Nasdaq), the optical switch maker. It was a 2000
initial public offering, and its stock was once $300 per
share. When I recommended it to CrisisPoint traders, the
stock was $3.46 per share and on the verge of being
delisted by the Nasdaq for failing to file its quarterly
report. The company’s audit committee was looking into how
employee stock options were accounted for in 1999 and 2000.
Sound risky? It has some risk, no doubt. But the bullish is
fairly simple. Sycamore has about $769 million in cash with
no debt, and its market cap was only about $950 million
when I recommended it. Because Sycamore burns through cash
at a rate of less than $10 million per quarter, it has
enough cash to survive for about two decades…even if its
profitability never improved!
Sycamore also has hundreds of millions of dollars in net
operating loss carryforwards, or NOLs, that could be used
to offset future income. That was going to be worth
something to somebody, I reasoned. When you add in the NOLs
and the cash, the rest of the company is trading for
The company has hired Morgan Stanley to advise it on
maximizing shareholder value, which could include
titillating options like selling the company, repurchasing
stock or issuing a special dividend.
An announcement to make any one of these moves could send
the stock soaring.
And the Markets…
WTI NYMEX CRUDE