Investing in troubled firms is a specialised art

I rarely buy a stock whose debt is greater than stockholders' equity, or corporate net worth per share. I?n effect, that means I won't give a second look to about one-third of US stocks. Bankruptcy risk is only part of my concern. Low debt confers freedom: It gives a company strategic options. High debt is like a straightjacket that can push companies into choices they would prefer not to make. High-debt companies may be forced to sell prized assets while keeping divisions that are dogs, simply because they need the money. They may fail to develop new products or make acquisitions because their lenders insist that new spending would violate debt covenants. Such problems are most likely to pop up at the outer edge of the debt continuum. Of 2,625 US companies with a market value of $500 million (Dh1,835m) or more, 69 have negative net worth; that is, their debts exceed their assets. On the balance sheet, they have a hole where stockholders' equity should be. Quite a few of these companies are familiar names, including airlines UAL and AMR, Freddie Mac and Fannie Mae, Domino's Pizza and Revlon. Readers of the business pages will also know Unisys (computers), Navistar International (trucks), Cablevision Systems (cable TV), and Dun & Bradstreet and Moody's, purveyors of financial information. Making noise Though small in number, these companies make lots of noise, and will account for a big share of the nasty headlines you'll see about struggling corporations in the next year or two. AMR, parent of American Airlines, has posted losses most years for the past decade. Its stock sells for about $10 a share, but the company's net worth as of December 31 was negative $10.49 a share. One of the biggest potential threats to airlines is rising fuel prices. Don't look now, but jet fuel is back up to about $2.13 a gallon, its highest level since October 2008. A solvent airline like Southwest Airlines can often afford to buy financial contracts that hedge against rising fuel costs. A struggling airline like American usually can't. That's one of many reasons why Southwest's market value, at about $9.5 billion, is almost triple AMR's. Domino's Pizza made a name for itself by delivering pizzas in 30 minutes. Subtract Domino's liabilities from assets and you get a figure of about negative $23 a share. Yet the stock sells for more than $13. Much better capitalised is rival Pizza Hut, which is owned by Yum! Brands. Yum had stockholders' equity of $1.1bn, and more than $350m in cash as at December 31. Domino's had stockholders' equity of negative $1.3bn, and $42m in cash. Which company do you think has a better chance of making a good acquisition or coming up with the pizza industry's next innovation? Not for amateurs Financially troubled companies often have sudden spurts of steep gains. That makes it tempting to play in this high-risk arena. Better see the Oscar-winning movie "The Hurt Locker" before you try it. This is a field strewn with landmines. Take UAL, for example. Since August, it has more than tripled, to about $19 from $6. Yet this is the same stock that declined to a little more than $3 in June 2009 from $48 in October 2007. Should anyone buy these stocks? Perhaps, but not most folks. The only people who should consider negative-net-worth companies are professional investors and speculators. Investing in troubled companies is a specialised art. It requires experience and "feel", as well as a thorough understanding of the target companies' balance sheets and statements. Most professional investors – and all amateurs, in my opinion – should avoid negative-net-worth companies like the plague. When you are considering a stock, be sure to check the balance sheet (assets and liabilities), not just the income statement (revenue and expenses). If a company's net worth is negative, run the other way. - Disclosure: I currently have no positions, personally or for clients, in any of the stocks discussed in this column. (John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column)