There is a common perception about value investing that it involves purchasing shares of companies on the brink of financial ruin with the hope they turn around. Viewed through this lens value investing is risky and the value investor one step away from experiencing individual ruin as their investments go bad all at once.
It's not hard to see where this perception could have come from. In the world of academic finance where everything can be reduced to a formula investment returns are a product of risk. Riskless assets generate no returns whereas supposedly risky assets generate outsized returns. Financial practitioners know what the academics don't, that life isn't a set of formulas. Assets that appear safe can turn out to be risky, and assets that appear risky might be safe.
The question is how can an investor find a safe asset for a depressed price? The answer to that lies in the distinction between different types of value investments.
In general low priced stocks can be broadly grouped into two opportunity sets: distressed investments, and neglected investments.
A distressed investment is any investment situation where the company is experiencing either business/operational distress or financial distress. These are the stereotypical "value" investments. Companies with operational difficulties trading at extremely low valuations.
An investment in a distressed company hinges on a few factors. The first is an investor needs to be able to determine whether the market reaction to the company's results is too pessimistic or if they're accurate. Then the investor needs to be able to determine if the company can recover from their operational difficulties. If an investor can determine both of these factors correctly it's likely they will be able to do well investing in distressed investments.
The trouble with distressed investments is determining when the future of the company doesn't look like the past. When a company faces a fundamental operating issue they need to innovate and solve their issue. If they can it's likely results in the future will resemble the past, or might even be better. If the company has a culture that can't react to their situation the chance that the future looks like the past becomes very small. Short sellers like to look for companies that have stumbled and don't have the business-DNA to reinvent themselves. Whereas distressed investors are looking for companies with that reinvention DNA. It's worth noting that very few companies change their business from one industry or market to another successfully. In many cases the odds are on the short sellers side.
Many novice value investors will find a distressed opportunity and presume the future will look like the past when in fact the business itself is undergoing a dramatic shift and it's likely the company will never recover their former glory.
With all these pitfalls distressed investing can be extremely profitable if done right. A company on the brink of bankruptcy and trading at 10% of book value might return 500% or 1,000% if they avert disaster. Where there's a chance for outsized returns there is also a chance for a complete loss. Companies straddling a thin line between solvency and bankruptcy court usually don't leave much residual value for shareholders.
Even though equity investing in distressed situations is risky one method to reduce risk is to invest is at a higher level in the capital structure such as through preferred stock, or debt.
I feel that distressed equity situations tend to have binary outcomes, either the company will do exceptionally well, or a tax write-off is in short order. I prefer a different type of value investment, the neglected company.
A neglected company is one that the market has mostly, or completely forgotten about. Sometimes the company's business is so boring it's hard to generate investor excitement. Investors, and especially the financial media likes whatever is popular or cutting edge. A landscaping company that schedules appointments via an iPhone is suddenly the Uber of landscaping. Whereas the hordes of other landscaping companies quickly fall into the camp of neglected investments, regardless of their investment merit.
The majority of my best investments have been neglected companies. Companies that are profitable, growing, and trading at depressed valuations because no one knows or cares about them.
In many ways a distressed investment is the opposite of a neglected investment. Companies that are neglected usually don't release news..ever. Neglected companies don't hold conference calls, and sometimes it's hard to even obtain financials for them. Neglected company CFO's are surprised any investors exist, especially ones that have intelligent questions to ask.
Distressed investors often live and die by the news flow. One news release or announcement can mean the difference between a vacation in the French Riviera or a stay at the Days Inn at the Jersey Shore.
Neglected investments don't appreciate 3-5x in a year, but they might compound in silence at 15% or 20% for decades, all while trading at a large discount to book value.
An investor interested in neglected companies doesn't need to predict the future. They just need a reasonable assumption that the future will be similar to the past.
The advantage to an investor looking at neglected investments is that these investments are not as risky. Neglected companies aren't facing an existential crisis. They can be great companies just operating outside the limelight.
Which is best?
I'm not sure there's a best way, but it's important to understand the differences in each investment you look at on a stand alone basis. The worst mistakes happen when an investor believes a distressed company is merely neglected. When this happens the investor misses a significant source of risk in their investment. The converse can also be true. An investor mistakes a neglected company for a distressed investment and never invests. There are many neglected companies silently grinding out significant returns for shareholders.