Belly-up, Chapter 11, collapsed, insolvent. There are a lot of ways to put it, but no matter how you phrase it, bankruptcy is a raw deal for stock investors. As soon as a company files for bankruptcy protection, creditors move in from all sides like vultures ready to pick the carrion clean before equity holders can even get within sniffing distance.
Just over the past couple of years, we've seen some of the largest bankruptcies in U.S. history, including Lehman Brothers, Washington Mutual, and General Motors. And while these bankrupt companies do still have shares quoted on the pink sheets, there seems little hope that the shareholders will walk away with anything.
So, how do you avoid being listed among the victims of the next major meltdown? Well Doc, let's take a look at a few ways to make sure your portfolio is free from bankruptcy risk.
Get interested in interest
Not paying a creditor his interest payment is a pretty surefire way to make him angry, so the first thing we want to do is make sure our companies have their interest obligations well covered.
There are a few different ways to measure this, but the most popular is to compare EBITDA -- a commonly used measure of cash flow that stands for earnings before interest, taxes, depreciation, and amortization -- to interest payments. Generally, you'll want the company's EBITDA to be, at the very least, three or more times interest payments to ensure that it can safely keep up.
To put some context to this, we can find that Coca-Cola (NYSE: KO ) produced $9.9 billion in EBITDA over the past 12 months and paid interest of only $400 million, giving it a very comfortable coverage ratio of nearly 25. Similarly, Wal-Mart's (NYSE: WMT ) $30 billion in EBITDA and $2.1 billion in interest payments gave it a safe 14 times coverage ratio.
On the flip side, Alcatel-Lucent's (NYSE: ALU ) $500 million in interest payments and $1.3 billion in EBITDA gave it a slim 2.5 coverage ratio. And with $700 million in EBITDA to take care of around $375 million in interest payments, gambling heavyweight Las Vegas Sands (NYSE: LVS ) is cutting it close as well. Though I won't be so bold as to predict these companies are headed straight for bankruptcy, investors in their stocks need to be aware of the risks that these low coverage ratios entail.
How high can you pile debt?
While EBITDA-to-interest is probably my favorite measure of bankruptcy risk, debt-to-EBITDA brings the balance sheet into the picture and can show companies that are burdened with debt, even if they're not yet in dire straits. Most creditors will probably say that a debt-to-EBITDA ratio of five is the upper end of where they're comfortable.
Toyota (NYSE: TM ) , General Electric (NYSE: GE ) , and Caterpillar (NYSE: CAT ) , for instance, have all managed to keep their interest coverage ratio in a safe range, but all three also have debt-to-EBITDA ratios above five. Now, I'm certainly not implying that we're about to see a bankruptcy filing from these heavy hitters, but such elevated ratios in a less stable company could put it at real bankruptcy risk down the road should earnings become depressed. For these three names, the more likely risk would be lenders becoming leery of their huge piles of debt, which would make future borrowings tougher to come by or carry higher interest rates.
Hedge those bets
Thanks to the wide array of financial instruments available today, it's relatively easy for retail investors to use stock options as a way to hedge risky investments. Using an options hedge can be a good way to keep your peace of mind while still going after riskier stocks.
Take Las Vegas Sands for example. As noted above, the company definitely falls into the worrisome category when it comes to bankruptcy risk. However, you can buy put contracts guaranteeing that for a certain fixed time frame, somebody will buy that stock from you at a set price.
Currently, an investor in Las Vegas Sands can buy puts with a $5 strike price that last until January of next year for about $100 per 100 shares. This would allow the option holder to sell their Las Vegas Sands stock for $5 at any time between now and January 2010. Considering that the put buyer here is paying $100 to protect $776 worth of stock, the protection isn't cheap, but it may be worth it to the investor who wants to chase a potential multibagger while simultaneously playing defense against a complete loss.
Best of both worlds
To review once more:
- Insist on an EBITDA-to-interest ratio of three or above. Preferably well above.
- Look for debt-to-EBITDA ratios below five. Preferably well below.
- If you must dance with the devil, consider protecting your downside with put options.
In addition to protecting your investments, you can use options to get better entry points and generate income. We use tools like these as part of a comprehensive investing strategy in our $1 million real-money portfolio at Motley Fool Pro. If you'd like to learn more about these and other strategies, simply enter your e-mail in the box below.
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