I’ve had the controversial take that investors should avoid stocks with negative earnings.
This is because my research into the biggest bankruptcies of the 21st Century showed that negative earnings was the #1 most common characteristic of companies in the year before bankruptcy.
The following are snippets from my book Value Trap Indicator, which examined the financials of 12 companies in the years right before bankruptcy, including big names such as Lehman Brothers and Worldcom.
1—Circuit City
INTRO: When a high profile company collapses, people tend to take notice. Especially when it is a well-known retailer like Circuit City was. There were many contributing factors to the Circuit City bankruptcy, but it’s easy to say it was obvious with hindsight. Or was it?
CIRCUIT CITY FINANCIALS: Looking at the stock price for the outcomes gives quite a favorable result. With the Value Trap Indicator, you would’ve bought in 2005 around $10-$17, bought again in 2006 around $15-$25, and then sold in 2007 at around $19- $31. A quick double, and you would’ve avoided the bankruptcy! The Circuit City bankruptcy is a perfect example of how fast things can change, and what a value trap can really look like. In 2007 and 2008, Circuit City had all the makings of a value trap.
They continued to pay and increase their dividend. Their valuations sunk lower and lower as the price continued to fall. For all intents and purposes, it really seemed like you were getting a great deal on some unfavored assets!
You need to look at every category, and don’t ignore the glaring problem that a stock is showing you. In this case, the negative earnings are extremely problematic.
Look at the Circuit City example. All it took was 2 years of negative earnings before the business was done. And this was with a company with very nice financials in 2006 and 2005. Even the debt levels were low enough to ward off trouble. It was the lack of earnings that did them in.
2—Washington Mutual
INTRO: When people think of the Great Depression or financial hardships, the picture of lines of people scampering to get their money out of the bank comes to mind. When panic like this strikes, it looks like a scene straight out of a movie. During the Washington Mutual bankruptcy however, this was a reality. If one thing was certain, it was that the CEO of Washington Mutual was ambitious and had good intentions. While this attitude can be helpful, it doesn’t save someone from ignorance. The world is a harsh place, and you have to learn how it works.
WASHINGTON MUTUAL FINANCIALS: The first thing that really jumps out to me is the high dividend yield. This can both be a sign of a great value play or a sign of a dangerous value trap.
A high yield usually means that a stock price has been beaten down and can signify a great opportunity, if the negative sentiment is temporary and perhaps an overreaction. As long as the foundation of a company is solid, then this high yield signifies a great buying opportunity.
The dividend has been increasing every year and the payout ratio is satisfactory. Sure, the payout could be lower but it’s not at a high enough price to seem unsustainable and we don’t see a spike. So, the dividend side of this stock seems to check out.
But the first red flag appears when you look at the earnings. Negative earnings are terrible to see, remember how the magnitude of that was covered in the Circuit City bankruptcy. Other than that, the valuations are low. Should we really freak out about one red flag? What does the Value Trap Indicator have to say?
VALUE TRAP INDICATOR: Another issue comes to light. The debt to equity for this company is very high, and growing. Even for a company like a bank, which tends to be more highly leveraged than the typical company, a debt to equity as high as 12 leaves very little margin for error. A small bump in the road, maybe even one to the tune of $16 billion, could really put these assets in trouble. As we found out, this is exactly what happened. The Value Trap Indicator had Strong Sell (>800) signals all along the way, with 2005 being the exception (but it still kept you out of the stock).
3—Nortel
INTRO: If there ever was a company that fully represented the stock market during the early 2000’s, Nortel would be it. From being one of the biggest benefactors to the dot com boom, to being one of the biggest crashers, to accounting scandals, to failed restructuring and bankruptcy… the Nortel bankruptcy encompassed all of this and more…
…Economic theories such as the “greater fool theory” grew in acceptance and use, though it didn’t have a name at the time. The idea behind the greater fool theory is that it doesn’t matter what price you buy a stock at, because as long as the stock price keeps going up, there will always be a greater fool who is willing to buy it from you.
This strategy worked for investors during much of the late 1990’s. It created one of the biggest stock market booms that we had ever seen, and pushed stocks like Nortel up to towering highs. Nortel’s market capitalization got so high at one point that it was bigger than one third of the entire Toronto Stock Exchange index.
Nortel wasn’t even making money during this time, people just expected that profits would materialize in the new technological world. As you can imagine, it didn’t end like these investors expected. Once the dot com bubble popped, stocks that were driven up by the optimism were equally pummeled on the way down. Some, even most, didn’t survive through the crash. Negative earnings and other factors got the best of these stocks and bankrupted them.
NORTEL FINANCIALS: As we can see, the income statement was a mess. Three out of the four years show negative earnings. Even in the only profitable year, 2006, earnings were atrocious. Earnings numbers were so low that the P/E for that year was over 450. Keep in mind that Nortel could easily have been a value trap for investors in 2005 and 2004. Just looking at the P/B and cash flow numbers, the company was trading at a steep discount to its asset values. Assets that were found out to be worthless, confirmed by the Value Trap Indicator.
It sounds so obvious, yet again, this is a lesson that the general public never fully comprehends. When a company is losing money instead of making it, get out of the stock!
Investors had plenty of warning when it came to Nortel. During this same period of earnings tumult, the company also saw wild changes to its shareholder’s equity, which is why you see the sudden jump in the debt to equity and price to book numbers.
4—MF Global
INTRO: Some things don’t seem important until they are gone. Concerning the importance of liquidity, the public learned this the hard way with the MF Global bankruptcy…
…The nightmare-ish collapse of MF Global fittingly ended on October 31, 2011, when the company filed bankruptcy. Bad investments and bad management contributed to yet another black stain on the reputation of Wall Street, derivatives, and financial CEOs everywhere.
Obviously, this type of situation is one that doesn’t help anybody. Not the customers, not the shareholders, and not the employees. The question to ask is, “what caused the liquidity problems?”
Clearly, the company wasn’t in good shape. If it were, well then why would it have felt the need to make risky plays? What compels a management team to approve a potentially crippling investment of over $6 billion, unless desperate times call for it? If the company was fined repeatedly for poor risk supervision, then obviously it had been doing badly for quite some time.
Were they just incompetent, greedy, or were they desperate? We can’t know for sure, but a look into the financials can help us understand if the risky behavior was due to profitability problems.
MF GLOBAL FINANCIALS: As expected, we see that management has been doing a piss poor job even before the final liquidity problem. After 4 years of negative earnings and such low shareholder’s equity, is it any wonder that the company went bankrupt? You might notice that there aren’t any stock price values for the first quarter of 2008. That’s because the company had their IPO in 2007, and their reporting of 2008 includes part of 2007.
Incredibly, the company went from IPO to bankruptcy in less than 4 years. Just another piece of evidence that public companies are never too old or too young to face the consequences of bankruptcy.
5—AMR Corporation
Some industries in the stock market should just be avoided like the plague. It’s just a sad fact about the fairness of life. Some business plans are just better than others. For stubborn investors who didn’t believe this, the AMR bankruptcy proved them wrong.
The AMR Corporation is the parent company of American Airlines. American Airlines used to be traded with the ticker $AMR, until their restructuring led to the founding of AMR corp. on October 1, 1982 in Fort Worth, Texas. AMR also presided as parent company over other airline companies such as American Eagle Airlines, Executive Airlines and AmericanConnection. However, even they couldn’t escape the mass execution of airline stocks throughout the 80’s and 90’s.
The company filed for a Chapter 11 bankruptcy on November 29, 2011.
AMR CORPORATION FINANCIALS: Right away, we see the same conditions that are prevalent in many bankruptcies. Negative earnings in the last year before bankruptcy, with a recent history of little or no profitability.
It’s not surprising that the company didn’t pay a dividend, as it clearly couldn’t afford it. The big warning that investors should’ve heeded was in 2008, when the company had more total liabilities than total assets. Negative shareholder’s equity was another danger, and it caught up with AMR.
Most of the shareholders in 2008 did recognize the severity of the situation, and it is reflected in the price to book ratio. It’s at 4 in 2007 and drops to below 1 in 2009. This shows a general pessimism and a large sell off in the stock.
6—THQ
INTRO: Not all games are fun. Just ask the shareholders who held stock through the THQ bankruptcy. THQ built a reputation for making big bets in the gaming industry. Unfortunately, many of those big bets never paid off.
THQ FINANCIALS: THQ was clearly showing warning signs long before the actual bankruptcy took place. With negative earnings in each of the previous four years, shareholders had no business investing. The stock even showed negative shareholder’s equity in the final year before bankruptcy. Unsurprisingly, that was the final nail on the coffin. More liabilities than assets is unsustainable when you are losing money.
You can see that the company never really established a strong track record of success. Businesses should be netting positive earnings most years, and should be seeing consistent growth on top of that. A situation of consistent negative earnings indicates poor management or a poor business model, or both. The poor business model is really what did THQ in. I’m sure management made mistakes along the way, but even the best CEO can’t manufacture demand that isn’t there.
There’s an old proverb on Wall Street that says, “Don’t fight the tape”. It’s referring to the importance of not trying to bet against the trend.
While there is something to be said in the value of being a contrarian, it’s also wise to recognize positive or negative trends and jump in or get out. Or as Bruce Lee says, “be like water”. You can’t manufacture demand. You can only ride alongside it. So for crying out loud, find a good company that’s already making money and let the profits flood in!
