Too big to fail. These were the words that echoed into history books and characterized the shocking aftermath behind the Lehman Brothers bankruptcy.
The premise behind “too big to fail” was simple. There are certain companies on Wall Street that are so massive, so hopelessly intertwined with the everyday economy, that their collapse would mean the destruction of modern lifestyle as we know it.
Lehman Brothers was thought of as one of these kind of companies, with a peak market capitalization of $60 Billion before it went under. In the end though, big banks like Bank of America, Citibank, and AIG got bailouts while Lehman Brothers and their shareholders were left in the cold.
But how did it all start? How did they get to this point of no return?
Subprime Mortgage Crisis
Lehman Brothers was the perfect example of how to ride an investing bubble all the way up and then all the way down. You see, the company had built a substantial portfolio around mortgage backed securities. Not only that, but they were leveraging up to do it. As the housing bubble continued to cruise, Lehman’s profits exploded and catapulted the company from around $20 to over $125 per share.
While everybody remembers about the housing crisis, not many remember that the correction happened in 2005, and it was the resulting subprime mortgage crisis in 2007-2008 that really did in our economy. This subprime mortgage crisis crippled Lehman Brothers’ profitability and forced the closure of their subprime lender BNC Mortgage, before completely finishing them off.
This scandal was unique not only because of the sheer size of the bankruptcy, but because it’s pretty obvious that the major cause was the leveraging.
Sure there were cases of malfeasance where quarterly reports were smudged to look better, and grumblings about the increase of pay and bonuses for top executives during and leading up to the bankruptcy crisis… but the real reason for the Lehman Brothers bankruptcy was plain and simple, debt.
Now it’s easy to say that they had too much debt in hindsight, but I want to prove to you that it should’ve been obvious even to unsuspecting investors. The sheer number of shareholders who were taken aback by this bankruptcy should attest to how ignorant investors really are.
Let’s look at the last annual report filed before bankruptcy, in January of ‘08. Keep in mind that Lehman Brothers filed bankruptcy on September 15, 2008.
There was a 2 for 1 stock split in 2005, which means that the company had a very stable track record of growing revenue, earnings, EPS, and dividend. Even their net cash was increasing at a long term trend, but all of this growth came at a price.
When a company is growing at this kind of a torrid pace, you have to look at their debt levels and see if they are sustainable.
By far, the stock was attractively valued in almost all categories. Just look at how low their book value valuation and price to earnings multiple was (P/B and P/E). With a P/E below 15 and P/B below 2, this is usually the kind of thing I’m looking for.
But what does the Value Trap Indicator say? So far 5 of the 7 categories used in the 7 Steps to Understanding the Stock Market guide check out. The only 2 ratios not calculated above are P/S and Debt to Equity. Let’s see what those values are.
Wow. With a Debt to Equity of 29.73, Lehman Brothers was 29x more leveraged than the average company.
Of course you have to consider that Lehman Brothers was an investment bank, and that banks in the finance industry banks tend to be much more leveraged than average companies. If you consider that the average debt to equity for these finance companies is around 10, then Lehman Brothers was STILL almost 3x more leveraged than the average.
Think also about how the financial crisis changed strategies of bank managers across the country. With the bailouts and other financial failures seen throughout Wall Street, more companies are starting to realize that even though many other companies are carrying that high of a leverage load, it may not be the best course of action moving forward.
All that being said, the Value Trap Indicator doesn’t make exceptions based on the industry. You can find finance industry stocks that are conservative with their debt to equity levels, whether you are talking about banks or insurance companies.
VTI: Lehman Brothers Bankruptcy
Bottom line is that the Value Trap Indicator warned of Lehman Brothers troubles for a long time, with a Strong Sell signal in each of the last 4 years preceding bankruptcy.
This example shows you how much each individual category is important to the process. With a decent P/S ratio, Lehman Brothers had attractive valuations in 6 of the 7 categories. All it took was one bad category, debt to equity, to signal a company who was actually in trouble.
You’ll find that many investors just look at the attractive growth or income statements, and completely forget or disregard debt levels. A company who is fueled by a debt driven growth rate is like an athlete on steroids, spectacular yet unsustainable.
Of all the bankruptcy examples, the Lehman Brothers bankruptcy is perhaps the most memorable and the most eye-opening. There’s a reason why you can’t focus on just one or two ratios when investing, and story proves it.
The 7 categories that comprise the 7 Steps guide and the Value Trap Indicator are all included for a purpose. That purpose is to find any missing holes or imbalances.
Importance of Limiting Losses
A healthy company with nothing to hide is easy to spot, just as a company who is trying to hide the elephant in the room (like Lehman was). The problem is that Wall Street doesn’t profit from better informed investors, instead they profit on more transactions and bigger headlines. Good stocks are hard to find, but good education is even harder.
The prevalence of this situation will always keep me in business, but it will also open opportunities for average investors like you. Success can be found by limiting losses more so than maximizing gains will. If you remember this principle, you can compound your wealth at a much faster and uninterrupted pace.
Like Warren Buffett once said, “Rule number 1 is never lose money. Rule number 2 is never forget rule number 1.”
The Value Trap Indicator was designed to help you avoid losing money. As you can see, it would’ve prevented against the biggest bankruptcy of our time. Take heed of its warnings, and stay away from companies that might look pretty, but conceal venomous fangs.
This blog post is part of the Stock Market History series. This series tries to uncover what went wrong in the biggest stock market bankruptcies, and how investors can use these lessons to prevent major losses in their own portfolio. This Stock Market History series shows the Value Trap Indicator values in the years right before a company went bankrupt. As you’ll soon see, many of these bankruptcies could’ve been easily avoided by following the Value Trap Indicator.
Today, there’s one portfolio that utilizes the Value Trap Indicator to find the best deals in today’s market for continuous compounding and superior returns. Those stock buy ideas are published monthly in the Sather Research eLetter, complete with research and Value Trap Indicator values. To subscribe to the Sather Research eLetter, click the link.
**All Rights Reserved. Investing for Beginners 2014**
**2008 Stock Market History: Lehman Brothers Bankruptcy**