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12 Cautionary Bankrupt Stock Tales from the Irrationally Exuberant 2000s

The ultimate display of failure in the financial world is going bankrupt. As investors, our biggest risk is employing capital only to lose it all on a bankrupt stock. Fortunately, there have been some very public stock failures to learn from.

bankrupt stock

In this post we will examine 12 of the biggest bankruptcies from the 2000s. Some were large, some were small, but all of them had publicly posted financial numbers that foreshadowed trouble ahead.

That’s good news because diagnosing and understanding those numbers means that we can avoid future company failures. Like doctors who can identify and treat symptoms, investors can master bankruptcy situations and confidently invest– and actively monitor– their portfolio for the long term.

Take note of the similar characteristics among these stocks that go bankrupt.

Enron Bankruptcy

The Enron bankruptcy was among the most surprising and shocking events that the investing world has ever seen. Never before had a company once been held in such high regard, respected and even honored among the top companies in the Fortune 500 and across the world. This tragedy forever shook the confidence of the individual investor about Wall Street and the general integrity of mankind.

If you weren’t paying attention back then, you might not now realize the magnitude of what really happened. Not only was Enron a highly diversified company, dipping its toes in natural gas, electricity, paper and pulp, and communications, but it was also an undisputed leader in the energy space.

For investors at the time, everything seemed smooth. They paid a dividend at around 0.5% – 1%, they boasted steady and growing earnings, and even had a mostly average P/E ratio in the beginning of 1999, at around 30. Everything seemed to be going according to plan.

Just how well respected was Enron? Well, Fortune magazine had heralded the company as “America’s Most Innovative Company” for six years in a row. Behind the scenes, top executives were cooking the books and hiding company losses to avoid suspicion.

But even though the Enron bankruptcy is widely known as the accounting scandal that caught everyone off guard, I’d like to argue that a prudent investor would never have bought stock in the company in the first place. 

The way that Enron cooked the books was through a method called “mark-to-mark” accounting. What this would entail, according to “The Fall of a Wall Street Darling” by Investopedia, was the immediate credit of an expected asset’s profits. For example, the company would build an asset, like a power plant, and then would count earnings on that asset before they even materialized. After that Enron would transfer the asset to an off-the-books corporation, so that when the actual loss was accounted for, it wouldn’t affect Enron’s bottom line.

Now of course this is highly deceitful and unpredictable. There was no way for the average investor to be able to research and find out this was going on. But there were some other warning signs going on in the financial statements, ones that you’d only find out if you look past the superficial earnings and income numbers.

Lessons from a Bankrupt Stock: Enron

Every major valuation and metric popularly used by Wall Street showed Enron to be a good deal and good buy. However, their Debt to Equity ratio was steadily increasing and almost 5x greater than the average company.

A company that is confident enough to pay a dividend rarely goes bankrupt. Yet as we can see with this example, even the most trickiest of accounting gimmicks isn’t able to be hidden very well. While all categories seemed healthy, the balance sheet (with the debt to equity ratio) uncovered that the health of Enron was suspect, and that their earnings were unsustainable.

When you are investing in stocks out there, beware of an increasing Debt to Equity ratio. Even a strong leader in their field, such as Enron, is not invincible from the unforgiving consequences of overleverage.

Worldcom Bankruptcy

The years following the dot com boom were clouded with accounting scandals and bankruptcies. Shortly after the infamous Enron bankruptcy, in which a leading energy company was exposed for cooking the books, the world was rocked again by the biggest bankruptcy seen to that point, the Worldcom bankruptcy.

Worldcom was the nation’s second largest long distance carrier, behind AT&T. Like the Enron case, the former CEO quit just months before the bankruptcy disaster, yet his involvement in the fraud proved to follow him anyway with a 25 year federal sentence.

A failed acquisition attempt of phone company competitor Sprint preceded this groundbreaking event. Regulators had determined that this deal would violate monopoly laws, and blocked the transaction. Just three years later, the Worldcom bankruptcy became the biggest bankruptcy in U.S. history with $104 billion in prefiled assets.

For this company, the writing was on the wall and former CEO Bernard Ebbers knew it. Unbeknownst to the general public, Worldcom was clearly struggling in a declining telecommunications industry and shrinking profits.

The Sprint deal was a last ditch effort to save the health of a declining stock price, but when the deal fell through Ebbers faced a dilemma. He was trading options on company stock to fund other businesses, and because the price was declining, he was being forced into covering margin calls.

With the danger of his selling company stock leading to even worse stock declines, Ebbers convinced the board to loan him hundreds of millions of dollars to cover the margin calls. Not only did this lead to the infamous black stain on Worldcom, but it also didn’t work, as the stock continued to free fall all the way into bankruptcy.

Worldcom Fraud

The fraudulent behavior didn’t stop there. As Worldcom faced bigger and bigger losses, top executives formulated some tricky accounting engineering to fix their problems.

These executives propped up revenue numbers by creating a completely fabricated entry called “corporate unallocated revenue accounts”. It didn’t stop there. Instead of accurately recording “line costs” as expenses, Worldcom placed these in capital expenditures.

These two devious mistakes over inflated assets by over $10 billion and completely betrayed the investors brave enough to still support the company. Unfortunately, the bankruptcy news completely blindsided those investors.

To make matters more confusing, take a look at this. In 2001, Worldcom split its stock into two different groups. The ticker that used to be $WCOM split off into Worldcom Group stock ($WCOM) and MCI group stock ($MCIT). The MCI group stock, also known as a tracking stock, was an attempt to make Worldcom look better by separating its losses from the income statement.

While this temporary fix may have pacified troubled investors, with the tracking stock even paying a dividend to lure in more victims, the tracking stock was eventually closed down and converted back into $WCOM shares.

This recapitalization move again made things tricky for investors at that time. Because now, in the 2002 annual report, they were able to separate earnings into the $MCIT loser and $WCOM.

Worldcom finally filed bankruptcy on July 21, 2002. This was just 3 months after filing their confusing 2002 annual report.

The Worldcom bankruptcy is a perfect example of how messy the stock market can become. From management fraud to accounting fraud to insurmountable shareholder losses, this story shows the ugly and immoral side of Wall Street. But what can we learn?

Lessons from a Bankrupt Stock: Worldcom

The Enron case was different because the scandal wasn’t able to hide skyrocketing debt levels. Worldcom, on the other hand, made the stock seem perfectly reasonable until it was too late.

I really feel bad for those people who were negatively affected by this. They were basically powerless in all of this, and we can only hope that the new regulation will thwart potential offenders.

It doesn’t bring me much comfort to say this but investors following my methods would NOT have ever held Worldcom stock. One of my rules is to never buy a company that isn’t paying a dividend, and Worldcom never paid one (except for the $MCIT spin off that split from $WCOM).

I realize that this could’ve happened to any company, regardless of if they were paying a dividend or not. Sadly, it’s just one of those cases where you really see the importance of diversification.

Of course, it’s also a great example of the importance of using a trailing stop.

Don’t fear. While the beginning of the new century brought wild attention to accounting scandals and management deceit, the rest of the major bankruptcies proved to be much more obvious and avoidable.

Lehman Brothers Bankruptcy

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.

Lessons from a Bankrupt Stock: Lehman Brothers

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. 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.

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.”

Circuit City Bankruptcy

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 enjoyed a chief prosperity during the 80’s and 90’s. Business was booming and naturally, it was expanding. People were buying up everything in the stores, from electronics to appliances… it was starting to be known as the store to buy from before you head off to college.

But the good times didn’t last forever, and eventually it slowed down. The retail empire took a backseat to Best Buy. They stopped selling their profitable appliances. Growth diminished, before it became hard to get customers in the store at all.

By the time that the housing crisis meltdown hit and the economy entered into a full blown recession, Circuit City was on life support and couldn’t take it any more. On November 10, 2008, Circuit City filed for bankruptcy.

How could this have happened to such a great store? Of course there’s plenty of speculation, but former CEO Alan Wurtzel thinks that it’s because management didn’t adapt.

He blames executive pride, as well as the inability for radical change due to shareholder backlash, as contributing to the eventual demise. In an store selling technology, is it really a surprise that you need to be on your feet and can’t rely on the past?

These are questions that aren’t as obvious as they seem to be. Surely for Circuit City, these are questions that weren’t pondered enough and you see the consequences of that. But is it really that easy? Sure you can look back as you sit in your chair and say that this one factor was the final straw, but I don’t think it was ever that simple.

Risky Sector

Most people don’t realize that one of the riskiest sectors in the stock market is retail. I’ve written about this before, how the retail industry had the most major bankruptcies out of anyone since 1994.

Although retail is very well known and certain brands easily become household names, it is very hard to stay in business in that industry. There’s so many factors that I can’t give you just one reason, but it’s hard to argue with the facts.

So knowing this fact and then reexamining this story, it shouldn’t be that shocking that a company as well known as Circuit City went under. If you look at the numbers, it’s even less.

Lessons from a Bankrupt Stock: Circuit City

Again this goes back to what I’ve taught before. 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.

When you buy a company with negative earnings, you might as well go to the casino and put it all on black. Because when you buy a stock that is losing money you aren’t buying a business, you’re buying a liability with a chance of recovery. Sure it might just recover, but the risk isn’t worth it when there are literally thousands of companies out there with positive earnings. Just don’t do it!

Would you buy a broken down car at retail price? Or even if you bought it at a discount, is it worth it? Let’s pretend you actually did have mechanic skills. But imagine buying a car that you aren’t allowed to touch, and it’s going to be repaired by someone randomly off the street. No sane person would ever do that!

Yet millions of people do it in the stock market all the time. And the markets, customer wants and demands, and the health of industries and the economy is as random as can be! At least put yourself in a favorable position by buying a company that’s actually making money!

For Circuit City, 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.

Tribune Bankruptcy

The rise of the internet contributed to the downfall of traditional media, especially newspapers. Companies that had been running for over a hundred years were now in danger of losing their shirts. The Tribune bankruptcy was one such instance.

The way that the Tribune bankruptcy played out is quite a special one. While the business was definitely negatively affected by the internet and “new media”, they were in no means treading on dangerous territory.

That is, until an investor named Sam Zell took the company private on December 20, 2007 with a buyout of $34 a share. Zell thought he could save the company with this bold move, a leveraged buyout that instead crippled the company and put them in bankruptcy a year later.

tribune bankruptcy

With burgeoning debts and a crippled business model, Tribune filed for a Chapter 11 bankruptcy on December 8, 2008.

A chapter 11 bankruptcy is slightly different than the chapter 7 bankruptcy that we commonly hear about. The main difference is in how the debts are treated.

Ch. 7 vs. Ch. 11

A Chapter 7 bankruptcy is the more traditional variety when we think of bankruptcy. In it, all of a person’s or company’s assets are sold off and used to pay the debts. The advantage of the Chapter 7 is that oftentimes, some of the debts are forgiven and it becomes a pretty clean break.

The Chapter 11 bankruptcy is different. In this scenario, assets are not sold off and instead the debts are renegotiated. The debtor is given a chance to revise the terms of the loan to make payment. You can easily remember the difference between a chapter 7 and chapter 11 by the following terminology: Ch.7 is a liquidation, and a Ch.11 is a reorganization.

In the bankruptcies we’ve investigated so far, they’ve all been Chapter 11 bankruptcies. This is the most common bankruptcy when you are talking about corporations. Now what made this Ch. 11 bankruptcy so interesting was that it took four years to resolve. Quite a long time.

In the end, the Tribune bankruptcy was an example of a private buyout gone wrong. The good news for shareholders was that they got paid and got out, while Sam Zell took the brunt of the damage from the bankruptcy. To be fair, he was a big reason why it happened in the first place.

What Killed Tribune?

The story that this event paints is actually different from what really happened. What killed Tribune was not the dissolution of the newspaper, while it did have a minor effect. What really put the company down was the insane increase of leverage from 2007 to 2008, and this is what prompted the bankruptcy.

If there was no leveraged buyout, we may very well have never seen a Tribune bankruptcy in the first place. While we’ll never know for sure, we can look at the numbers to confirm this idea.

Right away we see the destruction that Sam Zell did to the company. He somehow managed to take a decent shareholder’s equity in 2006 and turn it into a shareholder’s deficit in 2007. A shareholder’s deficit means that a company has more total liabilities than total assets, and this is a situation you never want to be a part of as an investor.

You see, bankruptcy is pretty predictable. It happens when irresponsible management can’t pay their liabilities, or can’t turn a profit (which means they can’t pay their liabilities).

That is all that the stock market is about. If you can learn how to avoid bankruptcy situations, you keep your capital growing for much longer times.

Washington Mutual Bankruptcy

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 the 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.

The goal for Washington Mutual was to make them into the Walmart of banking. This meant catering to lower class individuals, and dealing with their inherent increased credit riskiness. For this bank, that meant marketing sketchy products like adjustable rate loans. They even pressured sales reps into overlooking asset or income limitations for borrowers.

Washington Mutual was a company that was angling to be “for the people”. Also known as WaMu, the company tried to be the “cool” bank in the midst of the uptight and traditional banks.

Turns out, they also ran their financials in the same way. The company appeared to defy the traditional rules of leverage and liabilities, until a $16 billion bank run on deposits left them to the whims of the FDIC and hurled shareholders into a nasty bankruptcy.

It’s easy to point the finger at the 9 day, $16 billion bank run for causing WaMu to go bankrupt. But this was a company with over $300 billion in assets. Something else had to have happened.

What gets lost in translation was that the 9 day bank run was prompted by a credit rating downgrade for Washington Mutual. A look into the financial statements helps us determine if their credit downgrade was really justified.

Lessons from a Bankrupt Stock: Washington Mutual

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 fundamental 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?

Another issue comes to light. The debt to equity for this company is very high, and growing. Even for a company like a bank, who 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.

Protect Your Capital

I work very hard for my money. The last thing I want to do with it is lose it, and so I take every precaution I can to guard it.

As we are continuing to learn, it often takes just one reason to wipe a company out. This is why you have to be strict with your investing rules, because being lenient on just one can result in a lot of lost money. Sometimes that means missing out on big gains, often in companies with massive valuations or debt loads.

You have to be ok with that. You can’t have your cake and eat it too. Preserving, growing, and compounding your capital means avoiding the sexy stocks. But, as was the case with WaMu, being sexy and loved by the public doesn’t always equal success.

Let this story be a lesson to the arrogant leaders who think that the rules of finance don’t apply to them. While innovations can be created in reckless abandon, more often than not companies run this way bite the dust. Creativity does spur new ideas, but smart business is what makes money.

The former Washington Mutual CEO was once quoted as saying, “We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe’s-Home Depot did to their industry. And I think if we’ve done our job, five years from now you’re not going to call us a bank.”

One thing is true about that. We certainly don’t call them a bank anymore.

Nortel Bankruptcy

If there ever was a company who 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 one of the biggest crashers, to accounting scandals, to failed restructuring and bankruptcy… the Nortel bankruptcy encompassed all of this and more.

So how did this all start? The wild ride known as the Nortel bankruptcy was thrust into the public eye during the late 90’s. Internet stocks were all the rage, as were any companies that serviced these stocks or were seen to be a part of the new technological revolution. Network and telecommunication stocks like Nortel were among the most popular during this time.

Investors expected computer networking to take over the world of business like never before. The technology itself was seeing exponential growth in efficiency which led to the same kind of growth in profits, or at least it should’ve. The general public thought this trend would never end.

The stock market reacted to all of this optimism accordingly. With expectations through the roof, stock prices followed. Companies during this time period didn’t even need to be turning a profit, as investors excused traditional valuation metrics as old and obsolete.

People saw the new technology as being part of a new world. They thought that they had entered a new era of investing, one where all of the old rules didn’t apply.

Economic theories such as the “greater fool theory” began to be more accepted and utilized, though it didn’t have a name at the time. The idea behind the greater fool theory is that it doesn’t matter at which price you buy a stock, 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 had to 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 got 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.

The Aftermath

However, Nortel survived. The stock price took an absolute beating, but the company was able to hang around until 2009. In the meantime, it was able to pick up the pieces from the dot com debacle and even rebound into profitability through major restructuring with new management.

Frank Dunn, the CEO at the time, was credited for turning around the company and launching them from their dark years in the red into positive net earnings in 2003. Dunn and his management team were promptly rewarded with hefty bonuses.

The victory was short lived, as it was discovered that the company had been fudging their books and misallocating figures. Investigators finally found errors in excess of $3 billion just relating to revenue alone. The lofty executive bonuses had to be paid back, though only 10% or so could be recouped.

Nortel picked up new management, survived the accounting scandal, and continued to plod on through years of mediocrity until the housing crisis recession put the nail on their coffin.

It’s kind of a sad story. To see such a fall from greatness, followed by a slow and painful death. Even another restructuring in 2008 couldn’t save Nortel.

What was the problem? Was data networking just not that profitable? Or did management just continue to fail, no matter who was put in position?

We have to look into the numbers to really find the answer. I think it was some combination of both, but I am just speculating. What we can learn from this is that there will be stocks who follow this same pattern again. Which stocks these will be nobody knows, but even as I write this there are several companies with low profitability and record high stock prices.

A company like Tesla continued to book annual earnings losses yet the stock kept rising higher and higher.

Companies like Netflix and Amazon continue to follow a straight line pattern upwards yet struggle with low profitability in relation to their share price.

These companies are undoubtedly leaders and innovators in their respective technological fields. Yet like Nortel learned, a claim to greatness means nothing if you don’t have the financials to back it up. No matter how high your stock price gets.

The Nortel bankruptcy story finally concluded with its filing on January 14, 2009. The once great telecommunications and data networking company, a leader since 1895, was dead.

Lessons from a Bankrupt Stock: Nortel

Let’s find the red flags behind this bankruptcy. If history teaches us anything, it’s that it is bound to repeat again. As investors, we don’t have to make the same mistakes that Nortel investors made.

The income statement was a mess. 3 out of the 4 years show negative earnings. Even in the only profitable year, 2006, earnings were atrocious. Those 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.

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 time 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.

While once a Wall Street darling, this company was never a prudent investment during the last years before finally going bankrupt.

Blockbuster Bankruptcy

Steve Jobs once said, “cannibalize your product or your competitors will do it for you.” In the case of videos, Netflix and Redbox were the new competition. This and more contributed to the blockbuster bankruptcy of Blockbuster Video.

Before the Blockbuster bankruptcy that was preceded by Hollywood Video’s bankruptcy, Blockbuster’s origin story sounded like every other good business success. Before the internet and Netflix, Blockbuster had carved out a very profitable business model.

DVDs, and VHS tapes before that, were bought just once. The inventory was then rented out and turned a profit on itself after just a few rentals. The same inventory then brought repeat business for as long as demand would allow. For some popular movies, this “free” profitability could last for years.

The products also saved the customer money. For the fraction of the cost of box office tickets or outright purchases, customers could view the titles they always wanted to see.

For decades, Blockbuster was the king of its industry. As the number of Netflix subscribers 10x-ed from 1 million in 2002 to 10 million, Blockbuster slowly started to die as it saw less and less traffic in its retail locations. The famed billionaire Carl Icahn did his best to try and revive the company, but it was too late. On September 23, 2010, Blockbuster filed bankruptcy.

For the young and trendy people, this bankruptcy came as no surprise. Their consumer habits had already shifted towards the more convenient Netflix. But for the “out of touch” investor, the bankruptcy should still have come as no surprise as well.

Like is the case with each of the bankruptcies we have studied, the writing is on the wall before a company files. Filing for bankruptcy is the last desperate surrender. So as investors, we can avoid getting axed by paying attention and knowing what to look for.

So what warning signs did Blockbuster show investors? Like always, I need to see hard proof. It’s easy to say that Netflix was going to take over Blockbuster, because we have perfect hindsight and the luxury of seeing these events already play out.

Lessons from a Bankrupt Stock: Blockbuster

I see a lot of things wrong with the numbers. But before I even get to that, you should know that the company lost money for every year reported by the annual reports except for 2007. Why investors ever thought that this was a good investment is beyond me. A company that operates in the red has no margin for error! We see that it eventually caught up here.

The next thing I notice is that right away is a declining top line. A business with a declining top line (or revenues), is going to have an extremely tough time increasing its earnings. The very definition of profit is revenue minus expenses, and when revenue is down there isn’t much a company can do.

The net income numbers steadily decline each and every year, which is an obvious disaster. Observe how many times investors could have exited the stock. With losing years in 2010, 2009, and 2008, there’s no reason to be gambling at that point.

Besides the obvious earnings numbers red flags, we also see a big red flag in shareholder’s equity. In the last year before the Blockbuster bankruptcy, shareholder’s equity became a shareholder’s deficit. That means that the company owes more than it owns.

Unlike in personal finance situations, the leniency for negative value like that is very slim for public companies. A company in that situation is usually backed into a corner with no where to go.

Finally, we also see no dividend payments in the history of the company, and this has a lot to do with their lack of profitability. In fact, the company even states in their annual report that they are not allowed to pay a dividend by Delaware Law because of their cash flow problems.

This is an easy example of poor financials if I ever saw one. Even the debt to equity levels get worse as their net income is crashing lower. Carl Icahn is a very smart man, but I honestly can’t comprehend what he saw in this company.

You see, you don’t have to be a trendy 20-something to realize that Blockbuster was headed towards bankruptcy. The numbers speak much louder than any market pundit would.

The importance of being able to observe these symptoms of poor business will aide you much more than any ability to forecast trends or perceive customer behavior. You don’t have to know what’s hot and what’s not, because it will always reflect in the numbers.

Diagnose Trouble First

In the competitive capitalistic system that we live in, the best products and services rise to the top while the inferior get destroyed. The old must die for the new to thrive.

As in the case of Blockbuster, the company that grew from a small software engineer’s brain into the juggernaut of the 90’s had to fall victim to the same forces that once helped it prosper. Just as life begins and ends, so do businesses and stocks.

Smart medical professionals can diagnose a serious problem and take preemptive measures to save a patient from death. They do this by learning from the countless trial-and-error cases that have led to death or recovery.

In the same token, you must do this with your investing. If you’ve never studied why a company died, you’ll never recognize when another one is about to befall the same fate. The vital signs of Blockbuster were all pointing south. Sure enough, the company went bankrupt and shareholders lost all those shares.

The best way to improve your investing results is by eliminating your biggest losers. While we can’t prevent against stock market crashes and bear market panics, which are short term stumbling blocks anyways, we can prepare against worst case scenarios.

You can only reach the ultimate form of power when you have nothing to fear. Learn to never fear your worst case scenario, and the world will be yours.

Fearlessness breeds success.

MF Global Bankruptcy

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.

MF Global was a global derivatives broker providing many various financial instruments. The key word in there was global. Because the company’s reach spread through international waters, the way this debacle played out became increasingly complex.

After a series of poor decisions, a riskily placed bet of over $6 billion on bad European debt put the nail in the coffin. Scrambling to keep these bets viable, the company unforgivably transferred customers funds into their account. It only took a few days before the final bell tolled.

Due to recent events, the company had a bad reputation for poor decisions across its ranks already. A commodity trader at the firm tried to take advantage of a temporary shutdown in MF Global’s risk management system. Trying to turn a personal profit, he ended up losing the firm $141 million in ill-placed trades.

The fact that such a mistake took place reflects on the competency of the management there, who really take the lead behind the CEO. Turns out, the U.S. Commodity Futures Trading Commission recognized this and fined MF Global several times for risk supervision failure.

Today, there remains much investigation to the role that the CEO Jon Corzine had in all of this. In recent hearings, Corzine has admitted to not knowing much about the industry he is in and didn’t know any of the precise details behind MF Global’s liquidity issue.

One of the most impactful components behind the MF Global bankruptcy was the disappearance of $1.5 billion in customer funds. At the time of the bankruptcy filing, it was thought that this money was lost forever. Recent investigations have miraculously recovered all of that money, but this finding shouldn’t absolve Corzine and his associates from their crimes.

Regardless of this recent finding, the fact remains that MF Global took money from customers. This is never acceptable, and it reminds the public of a certain character named Bernie Madoff.

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 CEOs everywhere.

Takeaways

Obviously, this type of situation is one that doesn’t help anybody. Not the customers, not the shareholders, and not the employees. The things to ponder are what caused the liquidity problems.

Clearly the company wasn’t in good shape. If they were, well then why would they 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 continually fined for poor risk supervision, then obviously they’ve been doing bad for quite some time.

Were they just incompetent, greedy, or 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.

Like many of these bankruptcy cases, the problem isn’t always what made headlines. The headlines are often the symptoms of a deeper issue. We can’t avoid investing into a potential liquidity problem, but we can avoid investing into forced bad decisions because of bad financials.

Lessons from a Bankrupt Stock: MF Global

As expected, management had been doing a 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 had to go bankrupt?

You might notice that there isn’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 never too young to face the consequences of bankruptcy.

Even though MF Global had low valuations compared to book value and cash flow, the company wasn’t able to turn that end of year cash into useful profits for shareholders. We see that most of Wall Street wasn’t fooled, as valuations below 1 for P/B and P/C below 5 show a general distaste for the stock.

These quite standard value investor valuations might trick a less experienced investor into thinking that they are buying low. This is why a thorough investigation into all 3 financial statements is so important.

The debt to equity ratios share just how dire the company’s condition was. This is the kind of over-leverage that reminds you of the Lehman Brothers bankruptcy. Sure it might be normal for financial firms to have more leverage than an average company, but that doesn’t mean you have to invest in that situation. Just ask all the investors in big banks during the housing crisis.

The excuse that “everyone is doing it” is a poor one. I don’t care if you deal with fancy pants financial instruments, the law of over-leverage still applies. The bankruptcy of MF Global is just another case of this proof.

Debt to equity should be around 1. Not 30 or 40 times that. You can find financial companies trading at such conservative debt levels, you just have to look harder.

When interest rates rise, or market panic strikes, you’ll be glad you did.

AMR Bankruptcy

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 was the parent company for the more famous 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. To really understand the history behind it, you have to become familiar with the history of the airline industry.

amr bankruptcy

The airline industry was heavily regulated until 1978 with the Airline Deregulation Act. This led to a glut of airline companies being created, which led to price wars and subsequent mass bankruptcies. Extremely high operating costs, in addition to big players squeezing out the little guy through continuous lowering of prices, contributed to an absolute bloodbath for investors.

Over 250 airline companies have been created since the deregulation of 1978, with most of these companies eventually falling into bankruptcy. “Legacy carriers” became a term to describe an airline that had started before 1978, and every single one fell victim to the same fate. Coincidentally, American Airlines was the last legacy carrier to file for bankruptcy.

Airline Stocks Are Terrible

The bottom line is that airline stocks have historically been a terrible investment. Similar to many of the railroad stocks in decades past, airline stocks just haven’t been able to create consistent, steady growth for long term shareholders.

Whether it’s because they are in the mass transportation business, or for other reasons previously discussed, these stocks have not done well and continue to perform this way.

Even the famous Virgin Airlines founder and entrepreneur extraordinaire Richard Branson has been quoted saying, “If you want to be a Millionaire, start with a billion dollars and launch a new airline.”

The investing Oracle of Omaha, Warren Buffett, fell victim to the allure of airline stocks in 1989 with a large investment in U.S. Airways. After the stock performed miserably, he called his decision to surrender to the siren call of airlines as temporary insanity.

About this decision, he said, “There’s no worse business of size that I can think of than the airline business. You’re selling a commodity product with no variable costs. Huge fixed costs. It’s a terrible business.”

The legend really puts it succinctly. Airlines is a terrible business. Period.

Lessons from a Bankrupt Stock: AMR

The real lesson behind the AMR bankruptcy lies in this fact. Some business models are just plain better than others.

Some create gushes of cash with little capital expenditure, and these are the businesses that continually compound returns for investors. Other businesses continually burn cash and destroy any prospects of growth because more and more cash is needed to keep the lights on.

As an investor, it is your job to differentiate between the business models that have a great chance to succeed from the ones that don’t. It’s really not a hard process. By looking through the financial statements of a company, you can quickly see if it is healthy or not.

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 2008, when the company had more total liabilities than total assets. Negative shareholder’s equity is always dangerous, 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.

Strict Rules Are Necessary

You can see that there’s no magic number when it comes to bankruptcies. The net earnings actually show growth in the last 3 years, with each year being less worse than the last. But it doesn’t matter in the end. Losing money is losing money, no matter how brightly you try to paint it.

You must have strict rules if you want to truly protect your investments. That means no gray areas, and no possibly objective investment measures. It’s black or white. True or false.

In the case of bankruptcies, common themes occur over and over again. You’ll see negative earnings, really high or negative debt to equity, and/or no dividend payment. One of these 3 conditions doesn’t always equate into a bankruptcy. But it’s not worth your time to find out.

By cutting out these types of stocks from your portfolio, you can really start to see higher gains come to fruition. You might miss out on a miracle recovery story, but at least you’ll sleep at night.

Don’t think that you can lottery ticket your way to wealth. That is a poor person mindset. There are no shortcuts to wealth, and similarly no shortcuts to success. To really grow your wealth, you’ll need time and profitability.

A stock with poor financials has neither of these things. So avoid it.

Borders Bankruptcy

Ironically enough, as I write this there sits 5 packages from Amazon next to me. Amazon might’ve killed the bookstore, but Borders didn’t do much to help themselves. In the end, the Borders bankruptcy shows what happens when a company is slow to change.

I mention slow to change because Borders epitomized this characteristic. To say that they were slow to adapt to the internet would be an understatement.

When internet sales first started to get off the ground, Borders shot themselves in the foot by outsourcing all of their internet purchases to Amazon. This was a grave mistake that eventually crippled their bottom line, seen especially evident in 2006 and later.

In business, getting the customer is the name of the game. A business’s most likely customer is a previous customer. Borders failed to understand this miserably, giving away all of its online sales to Amazon from 2001-2008. What a way for Amazon to jump start their business!

That’s not the only way that Borders yielded to Amazon. Jeff Bezos, the founder of Amazon, figured out very quickly that the ebook was soon to take over the publishing space.

As a result, he made sure that his Kindle was the first e-reader to be released, in late 2007. Barnes and Noble wisely followed suit with their Nook release in 2009. Borders finally released the Kobo in 2010, but it was too little, too late.

The Borders bankruptcy could also thank the company’s inefficiency for contributing. In a time period where big box retailing was losing its allure, Borders continued to expand and insert their big box strategy into ill-suited locations. This predictably resulted in crushing liabilities in the form of binding lease agreements coupled with decreasing store traffic.

The miscues and lack of sound direction from management could very well be attributed to the fluctuating status of top level executives. What I mean is, management was constantly either leaving or being replaced.

Leading to the Borders Bankruptcy…

Borders started losing money in 2007. In 2009, the company cleaned ship. The CEO was replaced and given a severance package, the CFO was replaced, and 5 of the 8 board of directors were replaced as well.

The new CEO Ron Marshall only lasted a year before jumping ship, resigning and moving to be CEO of a different company. He had effectively convinced most if not all of the top executives to resign, including those who had faithfully worked in the company for over 20 years.

Of course, this all leads to speculation of the chicken versus the egg. Did the company collapse because the old management was all cleared out, or did old management destroy the business?

It’s hard to definitively say, and frankly, it doesn’t matter. What matters is that this ship was headed for the icebergs once it started losing money, and shareholders who were smart enough to jump onto lifeboats didn’t lose substantial investment like the rest of them did.

The final chapter of Borders’ book came on February 16, 2011, when they filed for Chapter 11 bankruptcy. The Ch. 11 was eventually converted to a Chapter 7, which just shows how miserable things really were. When it’s better to liquidate than re-organize, the business is failing catastrophically.

I’m guessing that the cold hard facts of this case will reveal that the bankruptcy could’ve been easily avoided by the average investor. Forget the internet and retail talk, and let’s dive in.

Lessons from a Bankrupt Stock: Borders

Like I mentioned before, the company was not profitable after 2006. Although it may have been able to prolong its survival, the bankruptcy filing was inevitable unless radical change and a recovery occurred. Neither of those things happened, and the company paid the price.

The debt to equity in 2010 was ridiculously high for a retailer. It’s too much debt for any company, let alone one that is fully dependent on the economic spending cycles of the consumer.

The debt to equity was also increasing every year. This is the only way that the company was able to stay afloat, and obviously that’s not sustainable. When you see debt levels growing at that fast of a pace, it should be triggering alarms all around your head.

Dividend Growth Investing Warning

Now, the big point I want to make was concerns the dividend payments. The dividend increased from 2007 to 2008.

Most dividend growth investors would keep holding the company stock because these payments are still growing. A dividend growth investor’s chief concern is dividends, and if that dividend is growing every year. Thus the name.

The problem with that strategy, while generally a very profitable one, is that you get into situations such as this one where the company is desperately trying to save face and act like everything is ok while in reality the crap is about to hit the fan. A dividend payment, especially an increase, is a bold statement by management to shareholders that business is doing well.

However, the business was very obviously not doing well. They lost money in 2007 and in 2008. A dividend investor should’ve gotten out at the first sign of negative earnings. If management isn’t going to be responsible, you have to be. Even if that means missing a few dividends.

Look at how bad investors got hit if they waited until AFTER dividend payments stopped to sell. An average of $8 a share in the first quarter, down from an average of $20 the previous year.

This is yet just another reason why I am so strong about selling stock on negative annual earnings. A loss of 50% or greater is not worth it to me to wait and find out if the business can recover. There’s too many other great businesses out there to put money in.

As always, the bankruptcy presented teaches us another valuable lesson on when to sell. It’s almost magical how each of these major bankruptcies teaches us something different.

As if the universe is trying to fully equip us against every bad situation.

I wouldn’t ignore it.

THQ Bankruptcy

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.

Take the example of their big game console accessory, the uDraw GameTablet. Originally released for new Nintendo Wii in 2010, this accessory allowed gamers to draw on a screen which would output into their TV screen. The only problem was, nobody wanted it.

A released version for the new Xbox 360 and Playstation 3 didn’t help matters. There just wasn’t demand for a $70 accessory that let you draw. THQ learned this the hard way, and spent a ton of money trying to make it work.

This wasn’t the only big bet that failed for the company. Most of their big-budget games were critically acclaimed but performed poorly in the marketplace.

The Importance of Marketing

Let this be a lesson to entrepreneurs and investors out there. Just because a product is engineered optimally doesn’t mean it will sell well.

You can’t discount the importance of marketing in a business. Products go around and profits are made because of consumer demand. As a business owner (which is what stockholders essentially are), you must have an intuitive feel for what the market demands. The products you produce must be highly desired.

It doesn’t matter how much money you pour into a project, if people don’t want or need it you won’t see success and thus won’t see profits. The stock market is all about profits. This is what drives the economy, and drives stock prices higher. Simple supply and demand. Forget about the demand side of the equation and you get a failing business.

Take a look at the other grand deals THQ had. With a basic monopoly on games based on the popular Nickelodeon and Pixar franchises, it seemed like THQ was destined for success. On paper, relations with Nickelodeon and Pixar sound like a sure fire money tree.

But in the end, the market doesn’t care about who you know or how prestigious you sound. Kids just didn’t care to pay for these games, especially with the rise of online games that were free to play.

Yet another well intentioned and expensive project that ended in disaster for THQ. With a rise towards the top of the gaming world in the early 2000’s, THQ could never catch its rivals and finally filed for bankruptcy in December of 2012.

How to Avoid the Bad Bets

At first, it sounds like you can’t blame investors. How were they supposed to know that the company’s products would fail in the market? Nobody can read the future, and it’s impossible to know whose products will rise to the cream of the crop.

But there is a way that investors could’ve avoided this THQ bankruptcy disaster. There always is. A company with a bad track record for wasting shareholder money is not going to be able to hide their faults. The truth will surface in the financials.

So this is where the importance of solid fundamental analysis becomes apparent once more. A company that has had historical success in the marketplace is more likely to repeat this performance. You can’t guarantee it, but you can quite easily differentiate the winners from the losers. You just have to see what they’ve done so far.

This is the average investor’s advantage. Although without the ability to personally screen and select management, the average investor can easily screen and sift through management’s performance in the financials.

Once a company has a winning product, it’s quite easy to parlay that success into many more. A lower budget and more efficient project gives way to more efficient projects.

Lessons from a Bankrupt Stock: THQ

THQ was clearly showing warning signs long before the actual bankruptcy took place. With negative earnings in each of the previous 4 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 completely unsustainable.

You can see that the company never really established a strong track record of success. Businesses should be netting positive earnings every year, 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 out. Or as Bruce Lee says, “be like water.”

You can’t manufacture demand. You can only ride alongside it. So find a good company that’s already making money and let the profits flood in.

Looking for More In-Depth Data?

I really hope I’ve given you extremely valuable information on these bankruptcies and the lessons we can learn to avoid them. This research fascinated me as I stumbled upon it, so I extended it to look at 30 bankruptcies from the 21st Century.

My findings led me to formulate an equation called the Value Trap Indicator. It’s a system using financial numbers such as the ones described above to automatically calculate if a stock is a Strong Buy or a Strong Sell. Of the 30 bankruptcies, the Value Trap Indicator would’ve kept an investor out of 29 of those stocks.

I also took the data from the 12 bankruptcies above, inputted them into my spreadsheet, and took screenshots to visually display the crucial publicly available financial data pertaining to these case studies.

This is all available in a PDF book format at valuetrapindicator.com.

Remember, almost every bankruptcy has clear red flags surrounding the stock for years before it finally fails. It may carry 1 red flag or 7, but the severity of even one shouldn’t be taken lightly.

If you take away one thing from this post, it should be that negative earnings or a high debt to equity level (caluclated as total liabilities divided by shareholder’s equity) are to be avoided at all costs. Any sort of “investment” with these characteristics in place is actually gambling.

Yes, many stocks do gain high returns with these metrics. But it’s not a sustainable approach for long term investing success. I hope I’ve proved that here.