Meet Sunny Jacobs...

At age 28, she was wrongly sentenced to death for the murder of two police officers – and spent 17 years in prison. A number of those years on death row.

Lucky for her, an organization called the Center on Wrongful Convictions took up her case. After getting the justice system to review the facts, she was released in 1992.

A few years later, she married another wrongly accused death row survivor, Peter Pringle. Today they live happily on a farm in western Ireland.

Companies that are victims of irrational fear across a broader sector – or maybe, a short-term bad decision – but that still have good balance sheets and a strong likelihood of paying back their debt.

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.

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.

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. 

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…

This may surprise you:

Investing successfully in distressed debt can be similar to investing in growth stocks.

When investing in growth companies, it’s critical to understand a company’s balance sheet. 

Because these types of companies typically need plenty of capital to fund their evolving businesses.

In a similar way, by analyzing a company’s capital structure, the terms of its debt, cash flows, and the demand of the company’s products, we determine if the company can meet their debt obligations.

It’s by fully examining these moving parts inside of a company, that we gain an edge in determining whether the security on sale is a bargain... or if it’s actually overpriced junk.

How to feel at ease buying pennies on the dollar…

As Howard Marks, the renowned distressed debt investor and co-founder of Oaktree Capital Management recalls from the 2008 financial crisis, there’s a level of contrarianism necessary to decipher where the real opportunities lie.

When a bond issuer defaults, investors will attempt to sell the bond on the secondary market. Fear, uncertainty, and doubt causes investors to panic sell.

Now, the original price the bondholder paid for the bond is underwater as the supply of sellers increases.

For the bonds we recommend to our members, we must be content that the borrower has enough resources to pay the interest and principal at the time of maturity to ensure a margin of safety…

And what we’ll be recommending will already be on “fire sale”… which puts us in position to generate spectacular gains!

Filtering Rite Aid through the “Sunny Jacobs” lens, Rite Aid was a basically good kid who made one mistake and definitely didn’t deserve to die.

If you gave this “comeback kid” a chance and bought their bonds, you saw a big payout.

Porter recommended this pharmacy company to his readers at Stansberry Research... and we think you’ll be interested to hear how the “drug deal” turned out for them.

In 2008, Rite Aid was the third largest drugstore chain in the United States and the largest on the East Coast.

Rite Aid overcame a disastrous tenure with its former CEO from in the mid to late 90s when he almost bankrupted the company as he went on acquisition sprees and began falsifying records.

In 1999, the CEO was removed, Rite Aid restructured and paid down its debt, and sold assets as well as new shares to recoup the losses.

From 2003 to 2006, Rite Aid was profitable, but the following year the company acquired a drug store chain with 1,850 stores. 

Rite Aid had more than 5,000 stores in 31 states, but the acquisition was financed with $1B in equity and $2B in new debt.

As a result of Rite Aid’s issuance of new debt, combined with the contraction in the credit market during the financial crisis and cash burn due to the integration costs from the acquisition, Rite Aid’s credit rating was downgraded from B- to CC+.

Rite Aid was an extremely well-known and established brand… but it was dispensing prescription drugs, an extremely valuable asset.

The new acquisition gave Rite Aid large-scale distribution on the East Coast and helped them establish their reach while improving efficiencies and reducing costs. 

The problem was, integrating the acquisition was expensive and Rite Aid’s sale’s growth was slow at the time.

Rite Aid’s business should generate plenty of cash to pay off its debts. 

Even in the case of bankruptcy, the company’s assets were still valuable as the demand for prescription drugs doesn’t change in a downturn.

Going back to 2003, the company was profitable, and the acquisition should have benefitted Rite Aid’s sales growth and margins over the long run.

The board was restructured, and conservatively projecting Rite Aid’s future cash flows indicated the company shouldn’t be at risk for defaulting. This created an amazing opportunity:

Impressive, right?

But let's be honest...

It took a lot of financial legwork to achieve this return.

The process we outlined in today’s article barely scratches the surface of what it takes to find opportunities like this. 

It’s an endlessly complex asset class that most investors – even professionals– simply cannot manage.

The good news is, you don’t have to do it alone.

Instead you can put Porter & Co’s newest analyst – Martin Fridson, Wall Street’s “Dean of High Yield,” to work for you. 

Plus, give you the details of two new distressed opportunities Martin and his team have already identified that we believe have huge profit potential in the coming debt default cycle.