Now that Blockbuster has formally declared bankruptcy, one of the first questions you should ask yourself as an investor is "Could I have seen that coming?" And the answer is a resounding "Yes!" For at least four years, the death of Blockbuster's shares was completely predictable.
Similarly, it was pretty obvious that the old General Motors was on a collision course with oblivion years before it finally gave up the ghost. With clairvoyant foresight, you could have shorted either stock and made a nearly 100% return in just a few years. Not bad, especially for fates that looked pretty much inevitable, even back then.
Can you try this at home?
Every once in awhile, a business' failure takes investors by surprise. Enron, for instance, looked like a healthy company until it was revealed that a huge swath of its business model was a scam. But quite often, the signs of impending doom are apparent long before the bankruptcy court gets involved. If you learn what to look for, you can get a sense of who's at risk of being the next corporate shoe to drop.
There are hree key factors that, when found in combination, will often tip you off to such troubles:
- A lousy balance sheet: Negative equity usually means either that the company routinely hemorrhages cash or that it made some huge -- and lousy -- investments.
- Regular losses: If the company routinely can't turn a profit, it simply won't stay in business for long, no matter how whiz-bang its products may be.
- Substantial business risks: If the market has made a company's product irrelevant or uneconomic or if its industry routinely produces failures, a company with the other two factors simply may not have the flexibility to adapt and survive.
If you look for companies with all three factors working against them, you may wind up with a list like this:
|
Company |
Shareholder Net Equity (in millions) |
Net Income
|
Business Risk |
|---|---|---|---|
|
UAL
|
($2,756.0) |
($106.0) |
The airline industry is prone to bankruptcies, and UAL has itself declared it in the past. |
|
Taubman Centers
|
($351.7) |
($61.7) |
Heavily dependent on mall shoppers. Online retail, discount chains, and a bad economy work against it. |
|
Incyte
|
($104.8) |
($164.5) |
Research-based biotech is often "feast or famine" -- either wild success or absolute failure. |
|
ArvinMeritor
|
($946.0) |
($28.0) |
The auto industry and its suppliers are prone to bankruptcies -- GM, Chrysler, Dana, etc. |
|
Rite Aid
|
($1,933.8) |
($562.9) |
Heavy debt load, dependent on single wholesaler for all brand-name prescription drug sales. |
|
Warner Music Group
|
($228.0) |
($115.0) |
Legal and pirated online music distribution reduces its control over pricing. |
|
Playboy Enterprises
|
($27.6) |
($35.2) |
Easy to substitute free online alternatives for many of its products. |
Financial data from CapitalIQ, a division of Standard & Poor's, as of Sept. 29.
Now, not every company on that list is certain to fail. Food and Drug Administration approval of a new product could cause Incyte's business to shine and its shares to skyrocket, for instance. But when lousy financials meet a tough industry -- like in UAL's and ArvinMeritor's cases -- supreme caution is certainly warranted.
And when new distribution channels make a company's model cost prohibitive, then you've got a situation that pretty much mirrors what happened to Blockbuster. Without substantially reinventing themselves -- and doing so quickly, given their balance sheet weakness and earnings shortfalls -- how exactly can Warner Music and Playboy survive?
Polish your crystal ball
It's fairly difficult to figure out where the "next big thing" that sets the world on fire will come from. Once that next big thing appears, however, it's a lot more straightforward to figure out who's likely to get run over by it. And that'll give you enough predictive ability to know which companies to either avoid or perhaps even consider selling short.
