Distressed investing has been a distinct style of investing for a couple of decades now. Many of us probably feel we understand the general gist of it–purchase bonds of a company that are trading at 50 cents on the dollar, or equity shares that are priced below their long-term value, and if you’ve done your homework right and the company turns around, the price rebounds and you make a killing. But what are the techniques that successful distressed investors employ? And what are the red flags that help one separate the wheat from the chaff?
The distressed investing space is quite large, and includes many different types of investments: secured and unsecured, senior and junior, public and private, and even credit default swaps, post restructuring equity, and other financial instruments. Securities are generally considered to be distressed if the issuing company is experiencing troubles that could lead to some type of restructuring, including the ultimate form—bankruptcy. Such restructurings generally result in some form of write-down of the company’s debts, as well as potential liquidation of assets. Thus, there is no doubt some heightened risk associated with distressed investing; but where some flee out of fear others rush in to find possible opportunities. As Baron Nathan Mayer Rothschild reputedly once said, “Buy when there’s blood in the streets.”
The significant and obvious risks of investing in insolvent companies, and those teetering on the edge, dictate that the distressed investor, by nature, is a deep value investor with a strong contrarian bend. It requires the keen understanding of the classic dichotomy so eloquently described by Warren Buffett, that “Price is what you pay, value is what you get.” One must believe that one knows better than the rest of the market, something Seth Klarman of the Baupost Group has referred to as a necessary arrogance, allowing one to see clearly whether a security is likely to go up in value, despite storm clouds that have caused the crowd to pack up and leave. But as Klarman also cautions, such arrogance must be tempered by a humility which acknowledges that the crowd actually may be right and your forecast based on wishful thinking.
Howard Marks, co-founder and chairman of Oaktree Capital, also comes to mind. His memos are a gold mine of information, shedding light on a mastery he possesses of not only the technical, quantitative aspects of investment analysis, but also the qualitative aspects that tie everything together. Oaktree’s investment philosophy is set forth quite succinctly In the business principles section of its site: “Our goal is excellence in investing. To us, this means achieving attractive returns without commensurate risk, an imbalance which can only be achieved in markets that are not ‘efficient.’ Although we strive for superior returns, our first priority is that our actions produce consistency, protection of capital, and superior performance in bad times.”
This speaks volumes about the critical investing concept of protecting against unnecessary risk. Aggressively seeking good returns, like the prospect of buying dollars for 50 cents, must be tempered with a diligent caution that minimizes the losses incurred through making bad choices. As Oaktree also explains, “We believe that the best long-term records are built more through the avoidance of losses in bad times than the achievement of superior relative returns in good times. Thus, our overriding belief is that if we avoid the losers, the winners will take care of themselves.” Clearly, this has worked well for them, as noted by Bloomberg in 2012 that, “Oaktree’s 17 distressed-debt funds have averaged annual gains of 19 percent after fees for the past 22 years — about 7 percentage points better than its peers tracked by Boston-based consulting firm Cambridge Associates LLC.”
We live in a time when many investors prefer to look at the market as being efficient, with active management adding minimal, if any, upside. It is possible to achieve consistently high returns though, and it doesn’t require that you personally identify and execute the distressed debt trades. The HFR distressed index, for example, made a hefty 12.7% in annualized returns from 1989 to 2010, as opposed to 8% for the S+P 500. So, investing in an index or fund of distressed securities can be a very satisfactory proposition, particularly if your time horizon is long enough.
Over the coming weeks, I’ll be writing more about what distressed securities are, how they are analyzed and how one can invest in them. In the meantime, perhaps start delving in to some of the below suggested reading items, to widen your scope of understanding and deepen your knowledge of what successful distressed investors look for when considering potential changes to their portfolios.
The Most Important Thing by Howard Marks – The author is a legend in the distressed investing space, and in the investing world at large. Warren Buffett said of the book, “This is that rarity, a useful book.” If it’s good enough to get Buffett’s approval, then you can be fairly well assured of its value. A peak at the memos available online might yield some good insight as well.
Distressed Debt Analysis by Stephen Moyer – One of the canonical texts, and a must read for people who are looking for an general introduction. This is one of the best places to start for one seeking to build a knowledgeable understanding. Spend enough time in the distressed investing space and you will undoubtedly come across this work and Moyers’ name sooner or later.
Distressed Investing: Principles and Techniques by Martin Whitman – Whitman is up there as one of the all-time great investors, like Buffett and Marks.
Creating Value Through Corporate Restructuring by Stuart Gilson – This is a “case study” type of book, excellent for someone who has a bit of experience.
No author bio available. Check LinkedIn for more information.
Opportunities in Bankruptcy: Turning Coal Into Diamonds
Dealing with Distress for Fun & Profit— Installment #18—How to Confirm a Chapter 11 Plan
A Primer on the Chief Restructuring Officer (CRO)
Battling Bankrupt Bargains – A Non-Debtor Perspective on Executory Contracts
The “Absolute Priority Rule” and Other “Rules” of “Priority” in Bankruptcy
Creditors’ Committees in Chapter 11 May Be Under Attack
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