As a reminder, you should always do your own due diligence when making your own investment decisions.
An exercise that investors don’t consider nearly enough is what will happen to their investment in a worst case scenario. In many cases — the worst case to a stockholder is that the company goes bankrupt: liabilities outnumber assets, and shareholders are wiped out.
Am I scaring you? I hope so. Every investment you make should be made with full awareness of the potential downsides. Even sexy companies such as Facebook or Amazon have potential downsides, where the perfect storm of competition, regulation, lawsuits, and other factors can bring any company to its knees or make a company obsolete with time. The question is how much margin of safety do you have, and how much risk are you willing to take?
It’s easier to dream about making money, than worry about the downside — and on the flip side, its easier to lose money than it is to make money.
Bankruptcies are topical here because I believe the market is pricing Intrepid Potash (IPI) for bankruptcy — meaning that the market believes that there is a good chance that IPI won’t exist in the future.
Strangely, if that happens to IPI, I might be OK with it. And if it doesn’t happen — then all the better. In any case, I don’t see a worst case scenario where shareholders are completely wiped out and we write all of our investments in IPI down to zero.
What’s interesting is that stockholders aren’t always wiped out in bankruptcies. Bankruptcies can happen, and have happened, to companies where assets outnumber liabilities. In these cases, companies have likely declared bankruptcy strategically, or because although they have lots of assets, they just don’t have the cash sitting on hand to pay their bills — and are forced by their creditors into bankruptcy.
The latter is a potential option for IPI if they are not able to renegotiate their debt covenants that they’ve stated they already have agreements in principle on.
If, and it’s a big if, that happens then the question is — what are IPI’s assets really worth, and if that value is more what we call a “margin of safety”, we can come out ahead. The margin of safety is basically the amount of money left over after debt is paid off, and after accounting for the cost of acquiring the company.
For example, in IPI’s case, our margin of safety is:
Now, with this margin of safety we know that of the $599 million in total assets and $150 million in potential assets, IPI needs to lose $468 million to leave us shareholders with zero gain, and then lose an additional $81 million to leave us with nothing.
If the company can get us the full $599 million and $150 million, we can potentially make $469/$81 = 5.8x our original investment.
Do I want the company to file for bankruptcy? Gosh no, I really hope it doesn’t and going through the bankruptcy process can be chaotic and lengthy. Obviously there’s more risk in a bankruptcy than not.
Am I prepared to hold on to my shares and hope for the best if it does? Yes. That’s why I think this exercise of “killing the company” is important before you go in and invest in a company.
What are things besides bankruptcy that I worry about? If the company is a fraud or if someone steals the assets for a 60% or higher discount from what they’re worth on the accounting statements.
Do you think that’s likely? Probably not — the Chairman/CEO and his Vice Chair own 25% of the company’s shares together, which to me reduces risk of fraud or fishy asset sales. Plus, I imagine and hope that if there are any fishy asset sales, we could use the U.S. court system as a place of last resort to enforce our fair claim on the company. Plus, I like that they have announced an agreement in principle with their creditors — even if that doesn’t guarantee they’ll be able to negotiate their debt covenants. Plus, I like that the CEO was buying shares as recently as May 2016 and started buying at $7 a share where now shares are close to $1. I also like how in recent quarters they’ve taken steps to idle mines and rationalize their cost structure to reduce their burn, and subsequently reduce risk of filing for bankruptcy.
Are you being too idealistic and can you be wrong? Probably, and maybe.
In a future post I may do a deeper dive into some of IPI’s assets to see what they’re worth (hopefully not zero and hopefully close to or more than $599 million).
We live in exciting times.
Are there stocks you own that you fear may someday declare bankruptcy?
I currently hold a position in the stock being discussed in this post, and am providing this information solely to share an example of how I look at investment opportunities and not to solicit or encourage investment.