As distressed debt investors, it’s important for us to understand a company’s business model and finances, and specifically its cash flows and capital structure.
Our investigations will be unflinching.
Because the two biggest risks we face are credit risk and default risk…
Regular bondholders face interest-rate risk, prepayment risk, downgrade risk, event risk, and some others.
But since we’re buying distressed corporate bonds, many of these don’t apply because the bonds we’re buying trade well below their face value.
But as for credit and default risk…
If a company’s credit deteriorates, we’ll have some risk of default.
If the issuer defaults, then we’re looking at losing part or even all of our investment. That’s why it’s so important to know what we own better than anyone else.
By turning over and examining every stone, we can apply a margin of safety to ensure the chance of default is completely minimized.
To do this, we’ll dig into the financials…
The balance sheet gives us our first glimpse of the financial health of the company and provides us a “screenshot” of the company’s assets, owners’ equity, and liabilities.
Digging deeper, the balance sheet reveals the value of the company’s assets, while the companies’ liabilities reflect the sources of capital used to fund the assets in the form of either debt or stockholders’ equity.
The income statement shows us the profits or losses from a company’s operations during a certain period, and if there’s a threat to the business which may cause revenues to decrease, or some other indication that a business’s free cash flow is on the decline – we’ll get to the bottom of it…
Because when future cash flows become more and more uncertain, the discount rate used to value these cash flows increases to account for greater risk.
This results in a lower enterprise value and the market value for the company’s assets decreases.
By deciphering whether a business is experiencing challenges due to cyclical changes or existential threats to their business model, we can learn a lot about the prospects of the company…
Take Goodyear Tire and Rubber Company, for instance.
The company may experience increased costs because of the higher price of rubber, which is cyclical and isn’t an existential threat to their business.
On the other hand, Blockbuster is an example of a business that faced an existential risk from competitors like Netflix.
(Fun fact: There’s now just one lonely Blockbuster left in the U.S. – in Bend, Oregon – serving as a tourist destination and curiosity.)
Here’s the bottom line in all of this…
Martin and his team employ a great deal of complex math and decades of experience when studying the reasons behind a company’s underperformance.
But for our purposes here, we’ll boil it down and use the Sunny Jacobs story to help you understand our process…