The news that Volkswagen was cheating tests measuring emissions of carbon monoxide from some of its diesel cars has caused a crisis at the car maker. Its share price has fallen sharply, as has public and investor confidence in it. Press reports have estimated that VW could face penalties of about $18bn (£12bn) for using software to cheat environmental regulations. Lengthy investigations by regulators and legal action look likely.

Yet to some investors, the crisis at Volkswagen represents an opportunity. Some fund managers that specialise in buying ‘distressed’ stocks (companies that have severe financial or operation problems and may be close to bankruptcy) reckon that Volkswagen’s shares have already fallen so much that they are bound to bounce back, possibly in a few years’ time, but still giving them a decent return on their investment. Other investors say investing in Volkswagen is too risky. This discussion often happens after a corporate scandal. 

Is there any systematic evidence that buying shares when their companies are in crisis, such as Volkswagen now, or BP after the oil spill in 2010, or Carnival Concordia (the company that owned the Costa Concordia cruise ship which sank in 2012), is more profitable than investing in, say, financially healthy companies?

Evidence gapInvestors interviewed for this article say there is not much, if any, definitive evidence or research showing that investing in the most distressed companies is profitable and, if so, by how much and how quickly, or if it’s more profitable than other types of investment.

Look at the share movements of some well-known distressed companies and the only common pattern is (unsurprisingly) a sudden fall in the share price after the bad news is announced. The time it takes a share price to recover varies, as does the time before a company collapses.

For example, on 19 April 2010, the day before the Deepwater Horizon oil platform explosion, BP’s share price on the London Stock Exchange was 642.50 pence. On 30 June 2010, it had roughly halved to 318.90. It has since risen and fallen. On 21 December 2015, BP’s share price was 335.20 pence.

The day before the Costa Concordia cruise ship sank, the share price of the ship’s owner, Carnival PLC, was 2,284 pence on the London Stock Exchange. On 17 January 2012, four days after the disaster, the shares had fallen by about 15%, but they recovered during that year. One year after the disaster (on 14 January 2013) the shares were 2,444 pence.

That recovery may be partly due to the sinking of the ship being a tragic but isolated and unusual event. The financial and legal implications of the disaster were less damaging to the company compared to, for example, BP in the aftermath of its oil spill.

Carnival PLC share price history for the period 2012–2016


Still, investors need to avoid ‘survivor bias’ – remembering the companies that recover from crisis and forgetting the ones that go under (such as Northern Rock, Maxwell Communication Corporation (owned by media tycoon, the late Robert Maxwell), and Enron).

When Enron, the US energy company, filed for bankruptcy on 2 December 2001, it was the largest public company bankruptcy in history. Its share price declined steadily during 2001 – in January, one Enron share was worth about $70, but by August it was less than $40, and by late November it was worth less than $1.

Shares in the British bank Northern Rock fell by 32% in mid-September 2007, the day after it asked for emergency funding from the Bank of England. In February that year the shares had been worth more than 1,200 pence, but on 18 February the following year, shares in the bank were suspended.

Northern Rock share price, January 2007 until suspension

Colin McLean, CEO of SVM Asset Management, an investment firm, reckons that you've got to judge each distressed company on its merits. Pay attention to how a company is run and its balance sheet, as this will give clues as to whether the company is likely to recover.

“You need to be sure that there are not underlying problems at a company,” advises McLean, who has been investing in stock markets for about 30 years and has experience buying distressed stocks. “Make sure that the company’s returns before [the crisis] were true and not over-inflated.”

Balance sheet analysisAlthough it is possible to make a profit on distressed stocks, he says it is a risky strategy and not many ‘value investors’ have recently made decent profits on buying into distressed companies. “Volatility has made it difficult for short traders to profit from these shares,” McLean says.

Paul Mumford has been running Cavendish Asset Management’s ‘Opportunities Fund’ for 26 years. He also runs UK-based funds. He says that there are two types of distressed company: fixable and unfixable. Volkswagen may well fall into the former, he says, although it’s too early to tell. 

“Volkswagen is in a crisis because, apparently, some of its employees cheated environmental regulations. It will probably face lengthy legal action and investigations by regulators and may have to restructure. There will probably be a steady supply of bad news about Volkswagen for at least the next couple of years. On the plus side, it is a strong brand and has the potential to recover.”
 
Another example of a distressed company with fixable problems, Mumford says, could be a small but fast-growing biotech company. The company has a promising medicine, which could become a multibillion pound ‘blockbuster’ drug. But the company is burning cash and needs more money to give it time to get the product approved by regulators and on to the market.

How do experienced investors spot distressed companies with intractable problems? One sign, according to Mumford, is if it is in a falling market, such as the UK retailer Woolworths, which was also laden with debt and unable to compete with discount retailers on price or quality, City analysts and business journalists said at the time.
“Very often the best long-term investments turn out to be the best short-term investmentsMumford advises having an investment plan of between five and ten years (“very often the best long-term investments turn out to be the best short-term investments”) and having a broad portfolio of shares, which minimises losses if a distressed company you’ve invested in never recovers or collapses. “For example, I may have about 70 or 75 stocks with about 1.5% of my portfolio in each one.”

Another tactic is to look for distressed sectors that are recovering, such as the house building sector in the UK, rather than a single company. “In a bull market, value investors [will be more active], but in a bear market the value investor will probably wait longer before buying a distressed stock,” he says. “I’d look at recovery areas in the market and buy them cheap and sell them when they are expensive. Value investors tend to be contra-cyclical [by] buying things that other people don’t like.”

Experienced investors, including ones interviewed for this article, still invest in distressed companies because, they say, the profits can be worth the risk. But given the scarcity of evidence about typical returns from this type of investment, or proven methods for predicting which crisis-hit companies’ stock will rebound (Carnival), or which company will collapse (Enron), or whose stock will not really recover (BP so far), it remains a fairly niche type of investment best suited for the most experienced investors. Steely nerves, backing a couple or handful of distressed companies in an industry with good profits and extra thorough analysis of the company’s balance sheet can improve the chance of making a decent profit from a crisis, veteran investors advise.