Peter Hodson: A bankruptcy is devastating, but it would be a mistake to let it put you off investing for good
Xebec Adsorption Inc. was a a once-popular $1.4-billion company in the clean-energy space that surprised many investors by filing for bankruptcy protection last September. Photo by Pierre Obendrauf/The Gazette Have you ever had one of your investments go bankrupt? You likely have if you have been in the stock business for more than 10 or 15 years. Companies go bankrupt. It happens. Nobody likes it, but it is part of any business cycle. Companies take risks and sometimes things backfire — badly.
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Most investors are comfortable with the idea, or at least accept, that stock prices sometimes go down. After all, the business/market cycle is highly variable, and no stock goes up in a straight line. But bankruptcies are different. They are final. A declining stock can always turn around and go back up. But once a company is bankrupt, that’s pretty much it. The chance of any recovery is typically just … gone.
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On occasion, a bankrupt company comes back from the dead. Sometimes bond holders end up with the company and/or get paid something on their original investment. But it is extremely rare for common shareholders to end up with much — if anything — in a bankruptcy filing.
Because of this, a bankruptcy can have a devastating psychological impact on an investor. It is, essentially, the ultimate failure. Your stock, which you once loved, or at least liked enough to buy, has gone to zero and is never coming back. It is enough to make one depressed enough to never buy a stock again.
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But that would be the wrong approach. Let’s play therapist today and offer five solutions to help fight the depression of owning a stock that heads into bankruptcy. For this exercise, we will reference the recent bankruptcy filing of Xebec Adsorption Inc., a once-popular $1.4-billion company in the clean-energy space that surprised many investors by filing for bankruptcy protection last September. Here goes.
Remember the math Whenever I have a losing investment, I remember my math classes. With any long position in an equity, the most you can ever lose is 100 per cent. In a bankruptcy, -100 per cent is most likely your final investment return. But you can make 200, 400, even 1,000 per cent or more when a stock works out well. You only need a couple of big winners and these could offset the losses on many losers, and even offset a few bankruptcies in your investment career.
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Article content Don’t blame yourself Sure, you’ve lost money in the bankruptcy, but you weren’t running the company. You didn’t send it into decline. You simply bought into a growth story that didn’t pan out. In Xebec’s case, margins on projects were much lower than executives expected, and this turned into a cash-flow problem. Management was not planning to fail. They lost money, too, as did those employees who no longer have a job.
Do not expect a recovery A company’s shares during a bankruptcy will often continue to trade, typically moving to the over-the-counter market in the United States. This was the case with Xebec, though it now barely trades at all. Time and time again, investors try to gamble when a company goes bankrupt and buy more shares, hoping for an ultimate recovery. But hope is not a valid investment strategy. Keep in mind, too, that capital losses can offset capital gains.
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Article content Experts also got it very wrong At one point, Xebec was a very popular stock. Seven full-time, professional analysts followed the company, and most had “buy” ratings for years. For example, National Bank of Canada had an outperform rating and a $9 target price on Xebec less than two years ago. If these full-time, highly paid professionals with access to management can still get it very wrong, then you shouldn’t blame yourself too much if one of your stocks goes south.
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Don’t let the experience turn you off the market Investors who have invested in a company that has declared bankruptcy may feel disappointed, frustrated and even angry. They may also feel a sense of betrayal if they had invested in the company based on the belief that it was financially stable. These feelings might cause investors to stop investing altogether, but that would be a mistake. Over time, even with the occasional large loss, investors can still do well if they own a balanced diversified portfolio. We would not let one bad apple ruin the batch.
Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)
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