Why Distressed Assets Are An Opportunity

Distressed assets can become appealing opportunities if caused by a systematic risk event. It sounds perverse, but investors should be excited by volatility, as it provides the opportunity to buy assets at a discounted price. This means that in times of low volatility, you should be gaining an understanding of how investments work, so as to know which to buy in the event of a sell off. 

Takeaways

• What are distressed assets

• Why they can be attractive to invest in

• The risks involved and what to look out for

• How to benefit without losing the house!

• Learn to develop your knowledge first

What are distressed assets?

A distressed asset is one where the market value is priced below its intrinsic value. This usually occurs because of a financial problem attached to that business. Although there are many types of distressed assets, we will focus on the ones which are caused by a black swan event.

During a world wide sell off, panic will set in. As a result indiscriminate selling will lead to good business trading at wide discounts. Identifying such undervalued stocks is possible, if you have used periods of low volatility to understand how businesses function. You will then know which businesses have been oversold.

Look beyond the horizon

After the March 2020 sell off, markets rebounded quickly but business which were specifically affected by lock down measures were left in the doldrums. Some of these industries, such as retail shops and restaurants, will likely never recover. Bricks and mortar retail has been supplanted by online buying, and there were already too many restaurants in the UK before the virus hit.

Yet cast your net widely and there are still opportunities to invest in areas where share prices have not recovered, but are attractive. Property investment funds, specifically investment trust ones, are still trading at a discount to net asset value.

The more it changes, the more it stays the same

Although the wide stream press has been quick to label the death of the office space, this may be a little premature. There will always be a need for an office, if not to train up younger generations, but for jobs which require cross-collaboration. Some employees actually want to work in an office.

Real estate investment trusts, such as Land Securities and British Land, entered the Coronavirus crisis having reduced their loan to value ratio to some of the lowest levels in recent history. Although they have collected less rent due to customer defaults, they are in a good position to survive. Sensible approaches to assisting customers such as setting up a relief fund points to good management.

Another real estate investment trust, Shaftesbury has suffered because it holds two thirds of its investments in Convent Garden. It too has seen defaults on rents due to the lack of tourism. But do we think that tourists will never flock back to Convent Garden once vaccines are discovered? Any contrarian investor will be looking closely at this opportunity.

The risk of a value trap

Distressed assets may also be distressed for a reason. You should do a thorough fundamental analysis of the financials behind the business. How much debt is there? When is the debt due? How much cash does the business have on hand to survive. Some businesses will be incredibly cheap because no-one wants to own them. This may be a clue that the downside risk is too big and you do not want to own them either!

How you can avoid the worst

Buying a distressed asset will give you the chance for out sized gains if it comes good. Typically if you buy it before anyone else and good news finally appears, you will see a large initial bounce in the shares, often in the region of 20/30%. Thereafter the shares will often continue drifting up 10/20% as the rest of the market catches up.

The problem you will have to wrestle with, is whether a business will recover. No amount of research can avoid a share price collapsing. Therefore give yourself a margin of safety by taking a smaller positions in higher risk investments. Only invest an amount of money you are comfortable losing, or that you can make back with one of your less risky investments.

Start small and with caution.

Be careful to over-invest your money in distressed assets. This is easily done by holding too many businesses which are exposed to the same trend, or holding more than 30% of your stock portfolio in recovery plays. Sensible investing would suggest that novice investors should only expose 10% of their overall portfolio at the absolute maximum to these kind of risky investment.

Conclusion

Investing in distressed assets should be the last area that a novice investor allocates capital too. It has the potential to lose you a lot of money. Although the returns can be attractive, it would be best to wait 2/3 years after you started investing before making your first moves. Ideally you would wait a full economic cycle (approximately 5 years) before entering this realm.

This caution expressed above will give you the time to develop your discipline as an investor. You will also have developed some control over your emotions. This will ensure that any positions you take are calculated ones. Finally your knowledge will be wide enough to know which firms to avoid as being too risky.

The writer of this article holds positions in Land Securities, British Land and Shaftesbury.