The Difference Between Down and Out
As turnaround investors, I prefer to invest in companies that are down but not out. This is important because a lot of times, investors misunderstood the two. Often times, these two types of companies are trading near or at their 52 week low. But the similarity ends there.
Company that is Down. This is the company that experiences problem and it seems like it can weather the problem. It just needs time to right the ship and get back on track. How can we be certain that the company can weather the storm? The ultimate guideline is to look at the company’s balance sheet and income statement. Does the company have a positive net cash? Is the company expected to post a profit? If the answer is yes to both questions, then the company in question is most likely is just down, but not out.
Company that is Out. This is the company that experiences problem but its future existence might be in doubt. It might right the ship but by then it might be too late. As a result, shareholders will be wiped out and lose 100% of their investment. How can we be certain for the company that is out? Again, we have to check the ultimate guideline, which is the balance sheet and income statement of the company. Does the company have a negative net cash? Is the company expected to post a loss for the foreseeable future? If the answer is yes to both questions, then the company in question has the high probability of being out of business.
Using analogy without illustrations are confusing, in my opinion. Therefore, I will choose one company for each situation. Please do not treat this as a buy or sell recommendation. This is merely my observation as someone who had watched these companies for a while.
Pfizer Inc. (PFE) might be categorized as the company that is down. Stock price slumped to 8 year low this week due to weak sales of its drug franchises and tepid guidance. Management has refused to update guidance for 2006 and beyond due to uncertainty. So, let’s look at Pfizer’s balance sheet, shall we? The latest information on Pfizer shows that the company has $ 15 Billion of cash and equivalent and $ 5.517 Billion in long term debt. In other words, Pfizer has $9.5 Billion of positive net cash. How about earnings? Is Pfizer expected to post a loss? Nope, it is expected to post earnings of $ 1.95 per share for year 2005 or $ 14 Billion of net profit. Profit is plenty while balance sheet is solid. Pfizer clearly is a company that simply has a small bump in the road.
How about AMR Corp (AMR)? This is an excellent example of a company that is out. Looking at the balance sheet, AMR has a negative net cash of $ 9.5 Billion. What this means is that it has $ 9.5 Billion more long term debt than it has cash. Is AMR profitable? Not a chance. It is expected to post a loss of $ 4.36 per share for 2005 or $ 714 Million. It doesn’t look pretty. High amount of debt and big loss is the recipe for a company that is down. If AMR doesn’t turn its ship anytime soon, it might be forced to file bankruptcy.
To consistently make money, investors need to be able to differentiate the company that is down and company that is out. Weed out the company that is out and your investment return will be so much better.