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About a month ago, I was asked by someone to articulate my portfolio strategy or investing philosophy. I have had one for a little bit, but with a lot of things, you find that the ideas are not as clearly defined as you might believe once you try to explain them to others. I bumbled through my response, mentioning one prong of my investment strategy dealing with "bankruptcy risks" and taking advantage of them. This was back in early December when the market was in the gutter so this topic was fresh on my mind. In hindsight, I realize I must have sounded insane, but it leads to this piece, with me trying to articulate my views further.

I consider myself fairly new to investing. I have followed the market all my adult life, but I only began to watch it closely back in January of last year. Bad timing, right? Well, in one sense it has been and in another sense, I feel like this was the best time to learn about investing as I have probably learned more about valuation right now than I could have ever learned in 2004 or 2006, just as a few examples.

One way I got interested in investing was through George Soros’s works. As my interest in investing, finance, and valuation grew, one of the first things I did was start monitoring Soros’s buying habits. One thing I noticed from Soros is that he buys into a lot of stocks that have bankruptcy risks priced in. These stocks don’t necessarily form the largest chunk of his portfolio, but he seems to jump in on quite a few of them.

When I first noticed this, I thought to myself, "is he insane?!" But then, I studied the market more and started to see why this might be a very brilliant strategy. Significant returns can be made on stocks with bankruptcy risks priced in if the companies involved do indeed survive. My basic thesis is that with a smart strategy and through prudent diversification, one can take advantage of bankruptcy risks priced into stocks and not expose one's self to too much unnecessary risk.

Bankruptcy Risks Defined

First things first --- it's important to clarify a few points: (1) markets will price bankruptcy risks into stocks that have little *real* bankruptcy risk at times and (2) one's own view of bankruptcy risks can differ significantly from the rest of the market. This is important to note because I am probably more likely to jump in if I believe the market is overreacting to the risks.

Over the past two months, a very significant chunk of the overall market has been priced with some degree of "bankruptcy risk" at various points in time. Some stocks have been priced with a minor bankruptcy risk. US Steel (X) back in early December was a good example. For a time, it was priced at about a 50% discount to book value in the $25-30 range. You could speculate as to the reasons for this, but I'd suggest the three major factors could be (1) belief that X would incur significant losses in the near-term, (2) belief that X's assets were overvalued, and (3) a bankruptcy risk stemming from X's moderate to high level of leverage (63.3% liability-to-value).

As I don't see much of a reason that X's total assets would depreciate in value significantly, factors (1) and (3) became more important to me; however, if you ignore factor #3 and ascribe the valuation solely to factor #1, that would suggest that investors believed that would X would incur heavy losses for nearly half-a-decade (going by a reasonable DCF analysis). Even in the ultra-bearish market, that seemed like a stretch to me, so I'd surmise that the market had priced an additional bankruptcy risk into US Steel. It's not a huge bankruptcy risk and I'd describe it as "minor" but it was still there. Arguably, with the price back in the lower $30 range, it might have a minor bankruptcy risk priced into it again.

While US Steel is a good example of a stock with a “minor bankruptcy risk” priced in, there are other stocks priced with a major bankruptcy risk. Back in December when Dryships (DRYS) was selling below $4, it appeared to have a major bankruptcy risk priced in. Dryships's book value is around $28; and that is probably understated a bit since that's from its last 20-F and it had significant cash flows earlier this year. Under $4, the stock was selling at more than an 85%-90% discount to book value. Certainly, things look very scary in the dry bulk shipping industry and the market is probably factoring in some heavy losses coupled with asset write-downs into DRYS's stock. However, even factoring in all of that, I find it hard to believe that the stock would be trading at an 85-90% discount with no other factors present. Given DRYS’s heavy leverage, I surmised the market had priced a “heavy bankruptcy risk” into Dryships' stock.

Going one step further, there are stocks priced with an almost-certain bankruptcy risk. Spansion (SPSN) would be a good example because its book value is around $9 per share, but the stock was selling below 15 cents per share right now. Given that heavy discount, it seems apparent that the market believes that this company is essentially a dead-man walking.

Taking Advantage of Risk

Now that I've gotten that out of the way, this next bit of logic is a debatable point: I believe that the market *tends* to price securities *more* on an individual level rather than on a collective level. What that means is that companies with a significant amount of leverage and hence, some amount of "bankruptcy risk", can get battered severely in downturns; but even assuming the worst, the overall industry might be underpriced.

Think of it this way: you want to buy a piece of fruit and you are willing to pay $1 for it if it's good quality. However, you never know for certain whether a particular fruit meets your standard of edibility. Based on this, you may assign a certain degree of risk to a particular piece of fruit based on what you can see externally. You might see a piece that looks like a sure-thing and be willing to pay 95 cents for it. But then you see a more questionable quality fruit and you're willing to pay 75 cents for it. However, if sales were particularly dismal, maybe the store discounts the "good looking" fruits to 90 cents and the "questionable quality" fruits to 40 cents.

At that point, while the "good looking" fruit is a more sure thing, you're really not making much of an economic gain on it (10 cent gain). Meanwhile, if you get a good fruit in the "questionable" bunch, you made a significant economic gain on it (60 cents). If you assigned the odds of the "good-looking fruit" as being 95% likely to meet your standards and the questionable quality fruit as 75% likely, it might be quite wise to simply buy the questionable quality bunch in larger quantities as the aggregate risk level would be much less than the individual risk level.

Hopefully that wasn't too ridiculous of an example, but this kind of goes into part of my investing philosophy. If I believe the steel sector is underpriced in the aggregate, I can buy in as a package deal and take advantage of the difference between individual risk and aggregate risk. As such, a portfolio of X, MT, and NUE might actually be fairly "safe" even if X and MT might be perceived as having some minor bankruptcy risks. Overall, I view it as unlikely that the entire steel sector goes bankrupt, so buying in the aggregate gives me a little bit more safety.

Personally, I tend stay away from the companies that I would describe as having "almost-certain" risk (such as SPSN) and I would suggest allocating a smaller portion of a portfolio to the "major" risk companies. My portfolio would then largely be made up of companies with "minor bankruptcy risks", as well as companies that don't seem to have any bankruptcy risks priced in. (As I said, this is only one prong of my overall investment strategy.)

Back to dry-bulk shipping, I might look at Diana Shipping's (DSX) low leverage and conclude its bankruptcy risk is low, but DryShips (DRYS) is high and maybe some other dry-bulkers have moderate risks. On that assumption, I might form a dry-bulk position in my portfolio of say 8%, and then assign 30% of that amount to DSX, 20% to a moderate-risk company, 20% to another moderate risk company, 15% to DRYS and another 15% to another high-risk company. This way, the less leveraged companies should hopefully help offset losses from the more leveraged companies.

The Experiment

Using Facebook's KaChing application, I built a fantasy portfolio in December that was partly based on the strategy articulated here. Now that the market has rebounded some, I might veer away from that strategy to some extent. Alternatively, if prices go down considerably again, I might shift right back to it.

My strategy had a great deal of success for awhile as I had achieved a 31% return at one point. I had to constantly re-evaluate risk versus reward and sold out of positions with some frequency. In particular, my dry bulk stocks all went up over 100% and I felt like the higher prices (and hence, lesser potential for reward) justified lessening my position in that sector. In this case, I still think there are bankruptcy risks for many of the dry-bulk shippers; I simply decided that risk didn’t justify reward and now I only hold smaller positions.

Over time, I've locked in about 9% of my gains. After the recent market plunge, my total return is now back down to 11% --- not nearly as impressive as the 31% I had at one time, but not bad, either. If my stocks start diving down much further, I will probably start buying in heavily again.

The Disclaimer

Mind you, I should clarify that my strategy is not to simply recklessly buy into companies with bankruptcy risks. Valuation is key and I would never suggest buying into a company with less than a 50% chance of survival. The key is to take advantage where the market exaggerates risks and diversify to take advantage of individual versus aggregate risk.

It is important to note that taking advantage of bankruptcy risks is really only one part of an overall investment philosophy. My overall strategy, like many others, is to take advantage of inefficient pricing. Taking advantage of bankruptcy risks is merely one way to do this. Another more tried-and-true way is to seek out small cap companies that are not heavily followed by analysts.

I don't believe my strategy is for everybody as buying medium- to high-risk securities doesn't fit into everyone's investment style or goals, but I think if one has patience and plays his or her cards wisely, it can be a very fruitful investment strategy. I’ll continue to evaluate the success of this strategy on portfolio management applications over time. I have not adopted this approach in my real life investing as I do not feel I have a large enough portfolio to make it as effective as I would like.

Disclosures: No position in any mentioned companies; however, the author may choose to purchase shares of X within the next two weeks.

Source: Take Advantage of Bankruptcy Risks in Portfolio Management