Money Matters - Simplified

How to Avoid Bankruptcy

If you've been investing the past couple of years, you don't need to be
told that risk matters now more than ever. After all, in 2007, 28,322
businesses filed for bankruptcy, while 14,319 filed in the first
quarter of 2009 alone.

That's one reason you need to be cautious when investing these days.
It's not enough to look at the income a company's generating. You have
to consider the viability of the business and the factors that could
cause it to fail.

It burns! It burns!

The most obvious way
a company can collapse is by consistently burning more cash than it
brings in -- and that can happen even when it's reporting profits. A
company may book income today, but only convert that asset into cash
years down the road.

For instance, before the credit markets locked up, First Marblehead's (NYSE: FMD)
business was securitizing student loans. The company would bundle loans
into asset-backed security tranches, then sell most of them while
keeping a portion for itself. It would book its tranche immediately as
income -- as it was required to do by accounting rules -- even though
it wouldn't receive cash from the tranche for years. 

A company could also burn cash while reporting profits by making
capital expenditures significantly in excess of the amount that it
books for depreciation. Since only depreciation shows up on the income
statement, a company's income could look fine, even with the company
bleeding cash.

To avoid these snares, carefully examine the company's cash flow
statement so that you can truly see how much cash the business is
generating. Investors who followed this strategy could have avoided
investing in WorldCom before it collapsed.

A stick and a fulcrum

Another cause of
dramatic collapses is leverage. Leverage can be great at magnifying the
upside, but it can equally magnify the downside.

It probably isn't a coincidence that Bear Stearns and Lehman
Brothers, which had survived and prospered for decades, died a few
years after they were allowed to increase their leverage from 10-to-1
to more than 30-to-1.

At 30-to-1 leverage, a company only needs its assets to go down by 3.5% to completely wipe out its equity.

So pay particular attention to leverage. That's not to say that you
should only buy businesses with no debt. Banking, for instance, only
makes sense as a business because banks are able to leverage their
equity to turn slim interest rate spreads into reasonable profits.

Rather, compare the business to others in its industry and to simple common sense. Though Morgan Stanley (NYSE: MS) and Merrill Lynch
survived leveraging themselves close to 30-to-1, it should be obvious
to anyone but an investment banker that that sort of leverage is
extremely risky.

Risky business

Even outside of industries that rely on leverage, risky business models can lead to bankruptcy. Take AIG (NYSE: AIG),
once considered among the biggest and safest insurers. AIG's business
model involves assessing the risk of bad events happening, pricing
insurance based on those risks and ensuring that single or multiple big
events cannot destroy the business.

But AIG made one little mistake -- it didn't recognize when it sold
credit default swaps that credit defaults can be highly correlated in
an over-leveraged, collapsing economy. The result is that AIG is now
essentially owned by the government.

You could argue that this was one bad decision by AIG, simple bad
luck instead of a risky business model. But its business model didn't
sufficiently prevent its taking on gobs of extra risk, which strikes me
as a problem of the model.

Some companies and industries are inherently risky -- think new
technology or development-stage biotech businesses. But even a company
with significant revenue can be vulnerable if it has only one product.

QLT (Nasdaq: QLTI),
for example, was doing well when its primary drug, Visudyne, was
considered the best treatment for macular degeneration, but struggled
greatly when competing medications entered the market.

The Foolish bottom line

Generally,
outstanding businesses generate large amounts of cash, don't need to
employ high leverage to achieve excellent returns, and cannot be struck
down by a single adverse event.

Microsoft (Nasdaq: MSFT), for instance, has been profitably growing for decades with minimal debt, despite battling IBM (NYSE: IBM), Oracle (Nasdaq: ORCL),
and even the U.S. Department of Justice. Not only is it unlikely to go
bust, it's the sort of business in which you should consider investing.

Of course, during more usual market environments, it can be
difficult to find these sorts of excellent businesses at reasonable
prices, but thanks to the recent market volatility, you can. There's no
need to buy risky companies that have any chance of failure when there
are so many amazing companies trading cheaply today.

If you're interested in ideas, our Motley Fool Inside Value
team has recently identified the eight stocks that we think should
comprise the core of a value portfolio. You can read about them with a
free trial. Just click here to get started.

 

Copyright 2009 by United Press International.