I have been asked several times in the last six to nine months about investing in some down and out company (Citigroup, GM, Nortel) on the thinking of “what’s the worst thing that happens? I lose a few pennies/dollars a share. If the company turns around, I can double or triple my investment!” What scares me is that half the people who ask me this question are deadly serious.
I tend to think of this type of stock investing as being in the hail mary school of thinking- named after the hail mary pass in football where you heave the football into the end-zone in some low percentage, high reward play made in desperation.
It is, in many respect, the flip side of penny stock investing. Put your money in a business who’s salad days are in the rear view mirror in the hopes that there is still enough goodwill in the market to effect a turnaround with smart management. Think of Apple. Nissan. Puma.
But is this an effective way to invest?
First and foremost, remember Buffet’s first rule of investing: never lose money. As much as we all want to cheer the underdog (and it is weird thinking of GM as an underdog), these are long shot bets and the chances of losing money are greater than the chances of a turn-around.
Second, another Buffetism is that “cheap is not good.” There is a reason why these once large businesses are trading at such a discount. Management ruined them. The market moved past them (Nortel). They got arrogant (GM). They engaged in illegal conduct (Enron). The market tends to be efficient over long periods of time and there is a reason the stock price is so low. You can only be mediocre for so long before everyone notices. Buffet always believes you invest in good businesses that have moderately higher valuations than bad businesses on discount.
Third, many down and out businesses have a de-listing and restructuring risk attached to it. How do you exit if the stock gets de-listed? In most restructurings, the shareholders get crammed down as well (typically, they are greatly diluted- see most airline restructurings). Thus, even if the business re-emerges from restructuring, an investor may not be in the same position as it was when you invested.
Apple is one of the few great turnaround stories in business history but it was never in such dire straits as some companies now and, as Job’s illness has proven, it is a business partially built on a cult of personality so it remains to be seen whether Apple can be a longer term success story (anyone find it odd that Manulife is taken to task for tardy disclosure but Apple is not for hiding the fact their CEO had major surgery? Last time I checked, Apple is not above the law- unless they made an app for that too).
In other words, successful hail marys are the exception rather than the rule so invest accordingly.
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