In a scene from the 1989 film When Harry met Sally, Harry (Billy Crystal) complains to Sally (Meg Ryan) that she is the worst kind of woman: one who claims to be low maintenance, but who, in fact, requires a lot of maintenance and attention.
Investors who buy a troubled share know without a doubt that they are in for a rocky ride. You will need to summon all your resolve and discipline, and keep a few Band-Aids handy for your bruised ego.
In my February 5 column, I wrote that shares could be broadly classified according to their sources of capital growth. I then discussed the factors you need to consider when investing in steadily growing shares. This week, I will look at the next category, the troubled shares.
Troubled shares are generally characterised as being out of favour with investors. The company has usually suffered such a precipitous decline in both profits and share price that market followers discard its shares en masse. Many of these companies may even be bordering on bankruptcy or perceived to be.
There are a number of reasons why companies get into this situation. They include over-expansion and the resultant cash crunch, reading their markets incorrectly, diversifying poorly or buying companies with unknown or under-estimated problems, bad management or something that could not have been predicted, such as an accident, a natural disaster or a protracted decline in their markets.
Sometimes a company may be out of favour with investors even though there is nothing seriously wrong with it. These are not troubled shares in the true sense of the term; they can be better described as contrarian or out-of-favour shares.
Three things frequently exacerbate the negative spiral in which a troubled company is caught up. They are:
- A difficult macro-economic environment. For example, in 1998, Edgars had to contend with internal problems and rising interest rates, and its share price dropped by 85 percent in less than three years.
- If a share is widely held by unit trust and retirement funds, further selling of the share is encouraged when the large institutional investors offload their sizeable holdings. Didata, for example, was one of the most widely held shares by unit trust funds in 2000 before its price plunged by 95 percent over the following three years.
- Professional investors become so tired of justifying a shareholding that is decreasing in value daily, and which glares at clients like the biggest mistake in investing history, that they sell it at all costs. They want to rid themselves of the embarrassment and move on.
In March 2003, when Didata was at R1.80, it was no longer among the top 10 shares held by unit trust funds after being a darling with investors for many years. Some commentators were even questioning the ability of the company to survive, let alone recover.
But this is precisely where opportunity beckons. Investors who correctly identify a company that is about to be turned around can pick it up at rock-bottom prices. In the case of Didata, investors who bought the share at R1.80 made a return of 170 percent in one year.
Identifying and buying the shares of a troubled company that is turned around is the ultimate in one-upmanship for an investor - the "I told you so" after thumbing your nose at the market. Fund managers can become legends overnight by calling one or two of these shares correctly in their career. At the same time, due to the risks involved in investing in troubled shares, if they get it wrong they are regarded as being negligent at worst or incompetent at best.
While the rewards are great, I cannot over-estimate the uncertainty that usually accompanies buying a troubled share.
It is quite tricky finding candidates for this type of investing at present, because we have been in an extended bull market. How-ever, many great turnaround opportunities are borne out of great bull markets, such as the aftermath of 1998.
It is important to remember that not all shares that are priced way below their historic highs when the rest of the market is booming are necessarily cheap or troubled. Instead, they may have been too expensively priced at their peak, as was the case with many of the information technology shares.
In the next column, I will discuss the factors you need to
consider when investing in troubled shares. I will also look
at some examples of troubled shares that presented great investment opportunities.