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The Zacks Rank is designed to show investors which stocks are seeing increases in earnings estimates. If you believe that earnings drive stock performance, then this is a very powerful tool. Some investors skin the cat a different way, choosing to wait until a stock is facing complete disaster… or at least something very close to that.

Distressed Investing

The old saying goes “when there is blood in the streets, buy” and for the investors that do this on a regular basis, it can be a profitable trade. At the same time, it can also very dangerous to the average investor that cannot watch the market all day.

When a company faces disaster, shareholders tend to shoot first and ask questions later. The preservation of capital is often more important than excess returns. That partially explains why stocks that fall a significant amount tend to see a bounce from the bottom, or a dead cat bounce.

But what about the companies that have seen that big drop, that massive rush to the exits? What happens to those stocks and who is there to buy the shares that a few hours ago, a few days ago, no one wanted? Well the distressed investor is there to take absorb the risk.

Lower Price, Less Risk?

Before we get to a few examples of distressed investing, we need to make sure we understand that the risk / reward ratio has changed drastically. As the price falls, one may think the risk decreases, but in fact it does not. The risk is actually a little greater in that distressed investors may not come to the recuse. Remember, at any time, the max loss in a stock is 100% of the invested capital. That is true of a stock bought at $70, $7 or $0.07.

The reward scenario, however, has likely changed drastically. Investors that had “weak hands” sold the stock as it was falling, but there is still a chance for a significant recovery. Often times that huge dip leads to a dead cat bounce, but distressed investors are usually in it for more than a quick trade. They want to see the stock return back to levels it saw before it was distressed.

If The Shorts Fit

Personally, I love the title I gave this section even if others do not. American Apparel (APP) is one of the stocks that fits the “distressed investing” molds. The company makes and sells branded fashion apparel, or what I call shorts, t-shirts and other casual wear items. The company, like several other retailers has been under substantial pressure over the last several quarters as discretionary spending is down and production costs continue to remain high.

APP also has some unique challenges and competencies that drew distressed investor Michael Bigger and his Bigger Capital Management to buy more than 3.27M shares of APP stock. The story line for APP became even more interesting when the Board of Directors removed CEO Dov Charney, potentially putting the company in an insolvent position.

In removing the CEO, the board put the company into what appeared to be a change of control situation that would make it default on certain debts it carried. The stock was trading around $0.60 at the time of the announcement, and just the headlines would make most battle hardened investors run for cover… and that is just what the they did in selling stock pushing it down back neat 52 week lows.

Since that time, new funding and a call for the removal of the board has produced gains of more than 100% as the stock has traded over $1.20. The “free” advertising from this event alone has put a very bright spotlight on the stock, company, products and management. That type of equation seems to be very positive for 3 out of the 4 mentioned above.

Beyond the press of this event, we need to look APP on its own merits. It is a smaller market cap company, with a valuation of right around $200M. That might keep a lot of investors out of it due to size, the $1.14 closing price on Friday might also keep some investors out. Interestingly, APP is a Zacks Rank #3 (Hold) but the fear of default on its debt has not really made it a huge short. Approximately 17% of the float is short, and while total shares short has increased from 13.1M at the end of May to 15.4M at the end of June, that is only about 7.5% of the total number of shares outstanding.

Crumbs From The Table

The cupcake bubble certainly hasn’t fully popped, the other day I saw a food truck in Chicago’s loop offering a $6 red velvet cupcake. The thought of me chomping down on such a delight brought a Homer Simpson-esque droll to my mouth. Then when I saw the bite size cupcake I became as like Dr. Bruce Banner and almost turned as green as a pistachio cupcake. Clearly, the bubble has not burst on this delectable fad.

Crumbs recently close its 70 or so cupcake shops across the country and an already distressed investment became a very distressed investment. The stock has been moving lower for some time, but when shares started trading for around a nickel, most people believed that the business was dead and it was time to move on.

Distressed investors, however, decided that it was time to take a closer look at the business of cupcakes and how this specific investment was performing. On July 10, the stock was trading at about $0.03 after the company announced it was filing bankruptcy. Then someone started buying shares around that level and before you knew it, the stock was trading at $0.40 at which point I tweeted:

And on StockTwits:

Guess there are a few more $CRMB left on the table... I bought a few thousand here.

— Brian Bolan (@bbolan1) Jul. 10 at 12:13 PM

Following those tweets, CRMBQ ran higher still to more than $0.76 the following day. This is nothing short of a meteoric rise! But like most meteors, it has since come back to earth, losing most of the initial gain.

Lessons Learned

I spoke with Michael Bigger about distressed investing for some deep insight from someone that has done this successfully. I came away with a few tips that apply to both distressed investing as well as "normal" investing.

Mr. Bigger noted that distressed investing is basically a binary event, with the result being bankruptcy or a big payout. When a stock gets on a distressed investors radar screen, as Mr. Bigger put it, "you already have a lot of the problem resolved." This means that all the bad news is already baked into the stock and the other issues are fully apparent.

This next idea is easily the most important. Mr. Bigger says that "whether you have the money or not, would you be proud of owning all of the asset." As much as that is a great way for distressed investors to think, it is very applicable to everyday investing. Too often investments become (losing) trades because there was no real pride of ownership in the stock.

A great example of the pride of ownership would be a stock like Tesla (TSLA - Free Report) , as holding this stock can make the investor feel like they are part of an automotive revolution. But it is also important to not let emotion rule your decision making. At the end of the day, investing is about making money with your money be it distressed or not.

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Brian Bolan is a Stock Strategist for He is the Editor in charge of the Zacks Home Run Investor service, a Buy and Hold service where he recommends the stocks in the portfolio.

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