Markets

Make Money Off Dying Companies

Landing a triple-digit winner is like hitting a hole-in-one. It doesn't happen often, but it's just as satisfying each time it happens.

However, there's an often overlooked subsection of the market that can lead to these types of gains -- but you have to understand where to look, what to look for and the dangers involved.

When shares of data storage firm OCZ Technology Group, Inc. (Nasdaq: OCZ ) slipped below $2 back in 2012, short sellers began to circle like sharks. The company was burning through cash at an unsustainable rate, and at the time, I noted that OCZ had "a very short window to stop the bleeding." By late 2013, the company declared bankruptcy.

Simply put, whenever you see a stock slip below the $3 mark, you may want to take a quick look at the balance sheet and cash flow statement. Falling levels of cash and persistently negative cash flow can often put a company out of business.

Such companies can try to buy time. When I looked at biofuels provider Gevo, Inc. (Nasdaq: GEVO ) back in 2012, I wrote that the company required serial capital infusions to stay afloat. At the time, shares traded for $1.50 and appeared poised to fall a lot lower.

To save face, management eventually pursued a 1-for-15 reverse stock split. Had they not done so, today shares would be trading for just $0.16.

And even when a company appears poised to enter liquidation in coming quarters, capital injections can hold off the Grim Reaper. In recent years, I have repeatedly written about the deep distress at retailer American Apparel, Inc. (NYSE: APP ), yet the company's stores remain open. Still, with $8 million in cash and $257 million in short and long-term debt on the books as of the end of 2014, how much longer can this ship stay afloat?

Frankly, it would be too hard to perform a comprehensive financial analysis of all stocks trading below $3. Yet you can focus your research efforts on industries in distress. Tough business conditions and weak balance sheets can be a toxic combination.

Right now, the retail and energy sectors have the toughest headwinds. In coming quarters, you will likely see more than a few bankruptcies in these sectors.

The key is to see which ones are truly troubled when it comes to cash and debt. In retail and energy, I've found two of them. They stand out as strong candidates for bankruptcy, and hold increasing appeal to short sellers. These investors consider such companies to be "terminal shorts," which means that can make a 100% profit if shares fall to zero.

Quiksilver, Inc. (NYSE: ZQK )

This company makes gear and apparel for the sun and surf crowd. Its sales peaked at $2.26 billion in fiscal (October) 2008, and will likely fall below $1.45 billion this year. The company appears to be on the down wave of a fad and is on pace for its second straight year of net losses.

Of greater concern, free cash flow has been sharply negative for four straight years. This has caused cash to fall to around $50 million, against more than $800 million in short and long-term debt. Lenders hate to see that and could eventually enforce debt covenants that pushes Quiksilver to seek bankruptcy protection.

Swift Energy Co. (NYSE: SFY )

There are many companies feeling the pain of too much capital spending and too little cash flow to cover it. The rebound of oil prices back into the $50 range surely helps, but it's clear that a number of oil and gas producers will need to seek fresh capital injections to stay afloat until industry conditions truly improve. Some firms may find the capital market spigot shut off. Bankers may not be inclined to lend to them, no matter the terms -- if the ability to re-pay such loans is doubtful.

Bond rating agency Moody's recently downgraded Swift Energy's bonds to SGL-4, its lowest rating. As of the end of 2014, Swift had just $400,000 in cash in the bank and more than $1 billion in debt. The company will provide a financial update on May 7, and investors will quickly scour the balance sheet and then listen for management commentary about how bankruptcy can be forestalled.

It's unfair to pick on Swift in isolation. It has many rivals in similar dire financial straits. Indeed, you should devote time this upcoming earnings season to the energy sector, as fresh signs of financial distress are bound to appear.

Risks To Consider: As an upside risk, these companies can sell stock to stay afloat, but that move would hammer share prices thanks to massive dilution.

Action To Take --> Whenever you see a stock tumble below the $3 mark, it pays to investigate its financial picture. You may be looking at the early warning signs of an eventual bankruptcy filing. Such a process can take several years to play out (as we've seen with companies like Gevo), but few investment opportunities offer the chance to double your money.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.