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Five ways to spot a dead company walking

I have shorted the stocks of over 200 businesses that have eventually declared bankruptcy. Profiting on these "dead companies walking" has gotten trickier since the financial crisis. Distressed firms have been able to stave off extinction by refinancing debt and tapping into the unprecedented bull market in equities. But even with our capital markets warped beyond recognition in this virtually failure-proof environment, corporate washouts are still far more common than most people believe.

Walking Dead Decomposed Zombie
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Walking Dead Decomposed Zombie

With an interest-rate hike all but inevitable in the near future, I expect more businesses to begin exhibiting these five telltale symptoms of imminent doom:

1) Declining revenues and mounting debt

These two problems might seem like they should be in separate categories, but they almost always occur together and they are usually the first signs of serious trouble for a business. Growing revenues are the lifeblood of any successful venture. When they begin to wane, debt loads tend to move in the opposite direction as struggling companies are forced to fund more of their operations on credit. Unless their fortunes change dramatically, firms trapped in this corporate death spiral rarely avoid bankruptcy.

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2) Overexpansion

I've seen countless businesses grow their way to disaster. Short-term successes convince management teams to leverage up their companies' balance sheets so that they can expand operations as rapidly as possible. This strategy usually boosts top-line revenues, at least for a little while, but it eats into margins and makes businesses less resilient to downturns. Energy companies are notorious for this behavior. During good times, they gleefully suck up debt and grow like weeds. But when the market shifts, as it has in the last six months, scores of them go from heroes to zeroes in a very short time.

3) Improbable new revenue-generation schemes

When times get tough, even the smartest, most accomplished corporate leaders often chase pink elephants. Rather than confronting the reality of their firms' predicament and shifting strategy (which usually means admitting their own mistakes), they tout dubious new opportunities. This happens all the time in the pharmaceutical sector. A popular drug will begin to lose marketshare and its maker will start churning out hopeful press releases about novel "off-label" uses or future windfalls from foreign sales. But those new uses rarely amount to significant revenue gains and the company's competitors are almost always pursuing the same overseas markets as they are.

4) Corporate bonds with ballooning yields-to-maturity

Bottom-feeding retail investors can keep even the ripest smelling stocks from going all the way to zero. Bond buyers are a different story. They are usually large institutional investors wielding huge amounts of capital. For that reason, a company's bond yields are a much more reliable indicator of its chances for failure — and when those yields climb above 20 percent, you're looking at the business equivalent of a code blue. The only people who are going near paper with that level of risk are corporate distress specialists looking to profit on the company's coming reorganization.

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5) A sunsetting industry

At some point in their downward journey to zero, almost every single dead company walking I have shorted has been a "cheap" stock on paper. Failure can be a slow-moving process, and even very troubled firms can show positive signs like decent cash flows or low stock multiples. These indicators often tempt value-oriented investors who fail to pay attention to wider secular shifts. I always like to remind people that the number of pay phones in America didn't peak until 1999. By then, cell phones were already well on their way to making those devices obsolete. But that didn't stop all sorts of respected Wall Street analysts from recommending pay phone company stocks. Like most investors, I spend a lot of my time buried in financial reports. But sometimes it pays to pull your head out of spreadsheets and projections long enough to ask yourself a basic question: Will this company even exist in five or ten years?

*A bonus symptom: insider selling when a stock is at or near 52-week lows.

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Investors tend to overreact to insider activity. It can be a useful indicator, but it's hard to gauge exactly why most executives or board members buy or sell their companies' stocks. They might be cashing out because one of their kids just got into an expensive college. However, if a stock is making consistent new lows at the same time as top insiders are bailing, something is definitely rotten in Denmark. This is a very rare occurrence. Out of the hundreds of companies I study a year, I might come across two or three instances of it — and it definitely grabs my attention when I do. If that same company is suffering from one or more of the other symptoms I've described, there's a good chance that I'll pick up my phone and short its stock.

Commentary by Scott Fearon, the founder and president of Crown Capital Management. He is also the author of "Dead Companies Walking: How a Hedge Fund Manager Finds Opportunity in Unexpected Places," which chronicles his 30 years of experience in the investment management industry.

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