Stocks to Avoid – Negative Equity

Figure 1: Negative equity on the balance sheet

There are also warning signs that indicate a stock is something you should steer clear of – or, if you already have it in your portfolio, consider offloading it sharpish. Or maybe it shows a stock you could short.

For example, negative equity.

Technically this is quite a difficult idea to understand, but it is easy to spot. Take look at this graphic from ADVFN of a company with negative equity in Figure 1.

See the stripy chunk in assets? That’s the amount of negative equity.

What is it? Negative Equity is the same for shareholders and for home owners. Negative Equity is when the amount you owe is more than the asset you own is worth.

If you borrow £300,000 on a house and it’s now worth £290,000, the negative equity is £10,000. As a home owner, you are £10,000 in the hole.

Companies can be the same. They owe more than all their assets. In a world without credit, it’s called bust, but in the world of corporate bonds and credit, it is called highly geared.

Avoid these companies and if you find one and it hasn’t fallen a long way you might think of shorting it.

Companies get this way because our friends ‘Private Equity’ buy companies with assets, then strip those assets out and pay themselves with them. The company then borrows a ton of money and the Private Equity people sell the company back onto the market; normally to our pension funds. These institutions are not bright enough to care they are buying a business back they only recently sold from the people they sold it to a couple of years back. Except now the company has had its assets plundered and is in a world of debt but for some reason is worth much more. It’s one of the more obviously legal crimes in the City: you couldn’t make it up.

The reason the companies can exist at all in this state is they make enough cash to pay down the loans from the profits they make and can keep the banks off their backs. If things get tricky, they go back to their new owners and ask for more capital via a rights issue to replace the cash recently stripped. It would be funny if your pension wasn’t footing the bill.

In theory if a company like this gets beaten down to the lowly value it’s really worth, it could be a good buy when and if good times roll. This is because coming back from the brink can do wonders for a share price. A booming period will help a company pay off its loans and get healthy again. Apparently this is an efficient capital structure.

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