At any given time, there exist stocks in the market where prices have collapsed. We are talking about ruinous returns, broken business models, failed companies, cyclical depression . Think WorldCom, Kodak, Enron, Peabody Energy. Crashing prices. Losses of 80% and more in a short period. Stocks like these trade at low prices for a reason. What once may have been a respected, widely-held large cap stock is now a despised and embarrassing penny stock subject to exchange delisting. Many times these companies go bankrupt and stockholders lose everything.
Other times a turnaround develops that offers favorable short-term trading opportunities. Some turnaround situations even prove to be long-term stock market winners going forward. It is important to recognize that a stock can represent a good investment risk even if it’s highly likely to decline in price and eventually become worthless. Let me explain.
The probability of losing money in a given stock is only one part the expected return equation. The other part is the payoff under a favorable future scenario. Do the math. If you can identify stocks with potential payoffs of 10x invested capital you can be completely wrong 80% of the time yet still earn a very favorable return overall. Think of an opportunity in the context of an overall portfolio, not of committing all available investment capital to a single asset or trade.
Once you have identified and researched the stock of a high-risk, high-return, turnaround situation, there are three ways to invest:
Listed options are a lower risk way to invest relative to stock if you limit your option exposure to an equivalent notional value of stock. If you are considering a $10,000 investment in stock, the correct risk-limiting option position is not $10,000 worth of call options. Rather it is a number of call option contracts representing $10,000 worth of underlying stock.
Stock is a more straightforward investment in a company than its listed options or distressed debt (bonds). Shares of stock trade more actively with better liquidity and the transaction costs are lower.
Distressed debt is safer than stock. In the event of bankruptcy a company’s bonds will perform better than its stock. Bondholders usually receive stock in a newly reorganized company while existing stockholders are wiped out. Evaluation of distressed debt is beyond the scope of this post but know that a corporate bond is subordinate to any outstanding commercial bank loans.
For a current bottom fishing example (not a recommendation) consider Peabody Energy (BTU). One of the largest coal miners in the world, BTU stock has crashed 93% over the past three years. Some analysts consider the stock to be undervalued. The table below compares potential returns of the stock, a call option and a company bond at varying stock prices.
The information contained herein is not a recommendation or offer to buy or sell securities. It is not intended to be fully comprehensive, nor does it consider the risk-return objectives and unique circumstances of any specific investor. If you have questions, please call Successful Portfolios LLC at (727) 744-3614.