Let’s start things off with a hypothetical situation. (I wrote something similar for Motley Fool last week, in the interest of full disclosure)
Say you and I were hanging out. FINALLY, A FRIEND FOR NELSON! TAKE THAT, DAD. I offer you a deal. You put in $20, and I flip a coin. If it comes up on heads, I’ll give you $60. If it comes up on tails, I get to keep your $20. Would you play that game?
I hope the answer is yes. If you could play that game all day long, you’d probably be a millionaire in a week. Once you had enough flips in to even the odds, you’d be effectively be making $20 on each toss. This would be an incredibly profitable game.
But what if I upped the ante? What if the game cost $10,000? Or $100,000? Would you still play? What if I limited the chances you had to just one coin flip? You still had great odds, but it would be a disaster if you guessed wrong.
I think I’d have far fewer people taking me up on the second offer. Risking your life savings on a coin flip is dumb, even if the odds are effectively in your favor. Winning is great, but losing is catastrophic.
How this relates to investing
I used this example for Motley Fool to prove a point about Penn West Petroleum. I’ll let you read the article if you want to learn more about it, but the skinny is this. The company has struggled for years, and now is facing the possibility of low oil prices hampering its ability to sell assets and ultimately pay down debt. If oil stays down for a long period of time, the company’s solvency could be called into question. If you were a debt holder, would you continue to hold if the company couldn’t afford to pay?
Because of this worst case scenario, Penn West is more hammered than a Scot watching a soccer match. Shares have dipped below $5.50 each, which is about a third of the company’s (probably inflated by a good 25% thanks to excessive goodwill) book value. As of this point the company still earns enough to pay the interest, keep its generous dividend afloat, and still have enough for capex, but that’ll get tighter if oil prices continue to decline.
I’m watching it, and will take a closer look once the inevitable dividend cut happens. I’d also like the company to sell a couple more assets to get the debt down a little more, so I’ll be patient. I’m usually too early on these types of investments anyway, I’m trying to stop doing that.
Penn West is pretty much exactly the kind of situation I described above. It could very well head to bankruptcy. If oil falls to $60 a barrel, I’m not sure how it will survive. Asset sales will stop, and it won’t have the cash flow to even service the debt.
But, if oil slowly recovers and it becomes business as usual again, the company won’t just survive, it could thrive. I could see it going up to $15 in a few years once it gets the house in order.
A portfolio of Penn Wests
If you poured all your money into Penn West and then borrowed more, you’d rightfully be laughed at — even if it succeeded. You know it’s a dumb move when I’d laugh at you.
But what if you found 15 different Penn Wests, each with the same odds as the coin flip scenario? If you had enough opportunities to invest at those kind of odds, you’d end up doing well almost by default. It becomes a numbers game, and eventually the numbers even themselves out.
The Winnipeg Jets have a goalie who stat guys say is among the worst in the league, Ondřej Pavelec. In the 2013-14 season, he was dead last in save percentage in the entire league (for goalies with a minimum of 40 games played), and dead last in goals against average.
And yet, he still had a shutout. In fact, he’s had 11 of them over his NHL career. And he’s had plenty of nights where he’s allowed one or two goals and been a really good goaltender. Even though most of the time he’s terrible (at least, compared to a regular NHL goalie to put things in perspective a little), he still has moments where he’ll buck the odds.
There’s just one problem with the coin flip analogy. There are three outcomes to investing in a troubled company, not just two. It can either succeed wildly, fail wildly, or not do much at all. If I were to guess, I’d say out of every 10 investments 1-2 fail, 5-6 are dead money, and 2-3 end up succeeding wildly, eventually tripling or more.
The whole point of qualitative analysis is to try to pick the best from the market’s reject bin. Ladies, think of it as going through the 90% off rack at Reitmans, a place I’m assuming you all shop at. Most of the stuff will be worse than a pancake stuffed with mustard, but there will be a few gems hidden among the crap.
The reason I hate debt on the balance sheet on a turnaround project so much is because it hampers the ability to turn things around.
The reason why I look for a company that has traded at a much higher price in the past is because that way investors can psychologically can more easily fall in love with a company again.
And so on. I look for these things not just because I want a margin of safety, but because I’m trying to skew the odds to my favor. Improving the fail ratio from 2 in 10 to 1 in 10 has a huge impact on returns. It’s an inexact science, but I think I’m getting better at it.
It sounds bad, but essentially we all do a form of coin flip investing. But instead of flipping for huge returns, most people are flipping for modest ones. Whatever floats your boat, but if you need me I’ll be doing my best to triple my money on coin flips.