On March 26, 2008, I posted the following:
“Looking for a few stocks to go short as the bear market continues to run its course? check out these below, as of the morning of Wednesday, March 26th. The usual disclaimers apply, I take absolutely no responsibility and you have to make your own entry/exit calls. If you know how to make good trading decisions, this should be no problem.

Symbol Company Tuesday’s closing price

ARGN Amerigon, Inc 16.15

CSGP Costar Group 43.55

GMCR Green Mtn Cof 31.79

LAMR Lamar Advertising 36.75

WFMI Whole Foods 33.21

TWI Titan Intl 31.97

TOL Toll Brothers 23.95

WGO Winnebago 18.14

And if you want more exposure on the short side, check out the ultrashort S&P 500 reverse ETF, (symbol: SDS). To profit from a decline in the spx you would go LONG this security.”

All of these positions (with the exception of GMCR) are showing a nice gain.  Three of these positions should be closed – ARGN, TWI, and WGO.  ARGN’s closing price yesterday was 2.5, TWI closed at 5.86, and WGO closed at 4.93.  That means the returns on these positions were 84.5%, 81.6%, and 72.8% (using yesterdays close as the exit price).  Not bad….  Also, I suggested to go long SDS on that day when it was at 62.86, it ended the day yesterday somewhere over 120 — over a 90% gain…. -John Bardacino

This strategy involves investing in the securities of a company that is or is expected to be in trouble. Some distressed securities can trade at large discounts to their actual risk adjusted basis. This is due to the psychological effect that occurs in the marketplace when a firm gets into trouble or files for bankruptcy.

The marketplace can be ruthless when it comes to punishing the prices of troubled firms, oftentimes going too far, and in the process this creates undervalued securities. Part of this is due to the fact that demand for these securities is hurt because institutional investment managers, such as insurance companies, pensions, foundations, endowments, banks, trustees, are prohibited from investing in securities that classify as distressed. This is due to the strict rules that many money managers must follow due to regulations such as the ERISA (Employee Retirement Income Security Act, which governs employee benefit trusts), as well as the “Prudent Man Rule”.

Although some trusts are set up to allow managers to put money in alternative investments such as distressed securities, in general most of the large institutions have a low tolerance for risk and volatility and shy away from distressed securities. Therefore, hedge funds have ample space to exploit inefficiencies that can occur when distressed securities become undervalued. They are the vultures who clean up the mess after the party (bubble), usually at great profit….

A firm’s securities can become distressed for several reasons: poor management leading to poor performance, too much leverage, accounting fraud, or competitive pressures. When a firm becomes distressed, its securities will eventually trade with the lowest credit rating.

I say eventually because despite the fact that rating agencies are supposed to assign credit ratings based on a company’s prospects of default, they have been a bit behind the curve when it comes to recognizing when a firm is in trouble. This has become especially evident most recently during the subprime crisis, as rating agencies came out with downgrades long after it was obvious that many of the firms that they had been giving top quality ratings to were in the process of going down in flames. It is important to keep in mind that when a firm actually files for chapter 7 or chapter 11 bankruptcy its stock usually loses all its value….

In my view, investing in distressed securities is a strategy that anyone who manages money should learn as much as they can about. As I am writing this the US and global economy is in the midst of what has become known as the “subprime crisis.” Financial Bubbles are the norm given the economic, social, and governmental frameworks that we live in. As long as humans are on this planet there will always be opportunities to make money in distressed securities, as the opportunity is inherent in the system.

Is there a risk that with so much liquidity floating around in global financial markets that the garbage will get chased by too much money and cease to have value? If recent bubbles are any indication, I doubt it. More liquidity means more market extremes, both on the upside and on the downside, and more liquidity means more malinvestments (bad investment projects that eventually lead to losses) which create distressed securities.

Smart people will move in to save certain companies if there is money to be made, while the garbage will be left to rot and decompose in the bankruptcy courts. But the opportunities will only increase as the economy becomes more globalized and the pace of change continues to increase. This has greatly sped up the process known as “creative distruction.”

In general, timing and patience are key skills with this strategy, however, short term traders can also reap rewards by exploiting the long term trends as entire industries rise and fall. The most recent example would be the housing bubble and its effect on homebuilders and mortgage companies. You don’t have to be a genius to exploit the long term trends, you just recognize what is happening and utilize it in a disciplined way, as explained in the first section of this book. Learn to utilize financial bubbles and the opportunities they create because there will only be more of them in the future.

There are three ways of investing/trading in distressed securities.

A. Simply short the stock of the distressed firm and hold the position as the firm’s position continues to worsen over time. The risk here is that the firm will get its act together and the stock price will recover. As in all situations, careful analysis of the situation is therefore warranted. However, when large financial bubbles burst and entire sectors of the economy collapse, as many mortgage firms are currently, it is not difficult to find a strong long term downward trend to trade with. If a firm is showing signs of trouble, how quickly it is forced into bankruptcy depends on the interaction between its cost of debt (interest cost), available cash flow and reserves, and the general trend of its industry.

B. Use capital structure arbitrage to exploit the relative value between a firms stock and its debt. Depending on what a firms capital structure looks like, it may have several levels of capital outstanding. Capital structure is the mix of equity and debt that a company uses to finance its business. How volatile a firms earnings are over time has a big effect on its capital structure.

Firms in industries that are especially sensitive to the business cycle, are research intensive, or highly exposed to product liability lawsuits usually will minimize the amount of debt in their capital structure. Conversely, firms in the utility and airline industries routinely use debt heavily and will have a capital structure with a much higher debt ratio. How vulnerable a company, and as a result its securities, is to financial distress depends the amount of debt in the company (debt ratio), its cost (interest rate), and its cash flow.

C. Go long securities that are deeply undervalued because of their distressed state. A distressed securities hedge fund manager will look closely at a firm’s reorganization or bankruptcy and go long its undervalued securities. Which securities it buys depends on the situation, the extent to which the bankruptcy process is underway, and what presents the most value and potential for gain for the hedge fund If the firm can cut a deal with its creditors and recover successfully, its securities will rise in value and the hedge fund will profit.

If a hedge fund manager is able to buy undervalued securities when a firm is in bankruptcy, the return to the trade depends on the entry price during bankruptcy and the eventual exit price after the firm (hopefully) recovers from bankruptcy. Something to keep in mind when analyzing opportunity in distressed companies is if the company has tangible, physical assets of value that someone would be willing to buy. What’s more likely to recover and emerge from being distressed: an airline company that owns a fleet of jets that was forced into bankruptcy through mismanagement or a tech company with rented office space and outdated intellectual capital that has no market price?….

I certainly do not recommend that the individual investor attempt to pick a top or bottom with event driven approaches. Attempting to figure out what is going to happen to securities in a bankruptcy proceeding is not worth the time or risk involved. Simply ride the price down when it is clear a firm is headed for major problems, and get out before the bottom is actually hit. And don’t attempt to go long anything in the middle of a bankruptcy or reorganization when anything can happen, the risk/reward is unfavorable for the individual trader at that point. Let the heroes pick the tops and bottoms. Stay disciplined and do not ask a price trend to give you more than it is willing to.

A good strategy to follow is a simple combination of the above strategies. Go long the securities of firms that are in the initial stages of recovery, and short firms that are in a distressed state. It can be difficult to get a diversified portfolio when following this strategy, as there are only so many firms that are in a distressed or recovery mode. –John Bardacino

It’s basically the “old style” hedge fund strategy, and many modern day hedge funds follow the equity long short or “equity hedge” strategy. But don’t let the name fool you… even though this strategy plays both long and short sides it should not by any means be considered neutral. This is a market directional strategy that requires two distinct portfolios: one consisting of long stock positions and the other short positions.
But it typically produces significant market exposure by being overall net long. But in practice it’s simple: you go long what is rising in price and go short what is declining in price….For example, if a manager were following this strategy, he would hold a portfolio that consisted of being long a group of individual growth stocks and short S&P futures, or a group of individual stocks he expected to decline.
The key is that there is more long exposure than short, so on net the portfolio as a whole is long. It is important to keep in mind that the amount or degree of this net long exposure varies depending on market conditions. In a strong trending bull market the short side of the portfolio would be minimized, increasing net long exposure. When prices are going down the amount of short positions would increase, dramatically decreasing net long exposure (while still remaining long on net). The benefit of this strategy lies in the ability to generate return from both the long and short side. Even though this strategy combines long and short positions it does produce systematic risk, meaning that it is affected by the direction of the market.

There are two methods to following the equity hedge strategy. They are the fundamental equity hedge strategy and the quantitative equity hedge strategy. The fundamental equity hedge strategy is driven from the bottom up, as individual stocks comprise the portfolio. Thus, competence with stock-picking and individual company analysis is a key skill in making this strategy a success. This is a viable strategy for many individual investors that manage their own money and enjoy doing research and analysis on individual companies, especially those who have an expertise in a certain market sector or market segment.

To implement this strategy, a manager could simply go long stocks in a hot sector and short stocks in a poorly performing sector and generate good returns. Clearly, the level of risk depends on the specific positions of the portfolio and the degree to which the portfolio is long on net.

But in general, do not be fooled by the level of risk exposure that can be generated by the equity hedge strategy. It can in fact entail significant risk. Traditional portfolio risk measures such as Beta rely on an assumption of a broadly diversified portfolio and thus can not accurately measure risk for portfolio strategies such as equity hedge due to the concentration in certain positions.

Unlike the fundamental strategy, the quantitative equity hedge strategy involves statistical arbitrage between a wide variety of markets. The kind of complex statistical arbitrage employed by large institutions and hedge funds is beyond what any individual investor would want to be concerned with. However, the concepts of the fundamental hedge strategy can certainly be understood and applied by most investors. It is a strategy that relies on the investors analytical skill in picking individual stocks, and market segments.

The equity hedge strategy depends heavily on manager skill and the ability to pick individual stocks that will increase in price as well as the ability to find stocks that are in trouble and declining in price. If you have this skill and the ability to successfully judge the correct amount of exposure in light of overall market conditions then this strategy may be right for you.
There is always an interplay between the broader market conditions and an individual stock and there are many ways to combine an investment style with a particular strategy such as this. As an example, you could go long stocks that fit the Ben Graham value investing approach while shorting overpriced stocks that are falling. Be careful though, because momentum can take an overpriced pig much farther than anyone can justify, or keep a quality stock in decline for extended periods. –John Bardacino