There is a temptation, particularly among novice value investors, to throw money at a stock that has fallen hard. ?Bargains are hard to pass up.

It can be worse if you owned the stock prior to the fall, and kept investing as it went down. ?There is the temptation to follow blindly the axiom, “Well, if you liked it before, you must love it now! ?Load the boat!” ?Far better to sit down and talk with a friend who has more skill than you, who does not own the stock, and if he/she has time, ask for his opinion. ?While you are waiting, go out to the web, and listen to the opinions (perhaps triumphal opinions) of those that did not like the stock. ?Particularly take note of:

• Allegations that the accounting is aggressive, or worse, crooked
• Claims that the management team has goals different than that of shareholders.
• Check to see that the balance sheet isn’t weak. ?Compare it to the balance sheets of competitors.
• Is there too much debt? ?Is there too much debt potentially coming due soon, and too little resources to pay the debt?
• Is revenue falling dramatically? ?What competitor is benefiting from the firm’s troubles?

But even if you didn’t own the stock, you might be wary of a stock that has fallen hard for a number of reasons, if the fall indicates the company may be in danger of default.

• It’s likely that the management team that is responsible for the problem is still in charge.
• Most ordinary management teams are not used to managing a company that is in distress.
• Suppliers become less likely to extend favorable credit terms to the firm.
• Rival companies spread rumors that you are going under and try to attract your best customers away.
• Talented employees look for greener pastures as opportunities dry up. ?It’s no fun to turn from growing a profitable business, to putting out fires.
• Management will be distracted with staying alive, maybe vulture investors, analysts seeking more data, regulatory requests, lenders seeking assurances, etc.
• Credit will be harder to get from bonds, loans, etc., and if the firm gets?it, it will be expensive. (Especially if the firm uses?the Financing Methods of Last Resort.)
• And, management may make things even tougher by having a round of layoffs. ?Less people to do the same work.
• Not only that, but even if you are right about the stock, there will be a lot of sellers selling as the stock price rises, because they got back to even.

When a company is in distress, everything fights against it. ?All of the normal courtesies are gone, replaced by a haze of suspicion. ?At the time it most needs friends, they vanish. ?Tempting as it may be to buy the stock quickly, it might be worth it to wait and see whether things get worse, and analyze who would like to buy the company to use?some subset of the assets for their?own company.

Now recently I read a classic Journal of Finance article called, “In Search of Distress Risk, by?Campbell, Hilscher, and Szilagyi.” [Download is for wonks only, I will summarize.] ?Distress tends to happen to firms that have negative price momentum, are small, and are classified as value stocks because of the high ratio of net worth to market capitalization. ?As a result, some suggested that the risk premiums that exist for owning small and value stocks must be related to distress. ?But firms under distress tend to do badly, while small and value stocks tend to do well. ?Negative momentum fits, but distress is a small part of that anomaly.

So maybe if you are a value investor or a small cap investor, you might be able to improve your performance by screening out distress situations. ?The simplified variables used in the paper are (and their effect on the probability of distress [page 2910]):

• Net Income / Total Assets (lower means higher probability of distress)
• Total Liabilities?/ Total Assets (higher means higher probability of distress)
• Three month total returns?(lower means higher probability of distress)
• Realized stock price volatility over the last three months?(higher means higher probability of distress)
• Market capitalization?(higher means higher probability of distress)
• Stock price under $15??(yes means higher probability of distress)
• Cash and near cash as a fraction of total assets (lower means higher probability of distress)
• Market to Book?(higher means higher probability of distress)

Most of these make intuitive sense. ?The one for market capitalization doesn’t except the the effect of a stock being under $15/share is more closely related to distress.

One thing that might make you change you mind is if a new management team is brought in. ?Every quarter I pull together a list of companies that have fired or replaced their CEO, and I throw them in as competitors against the existing companies in my portfolio. ?[there were about 80 over the last three months] A fresh set of eyes, a fresh mind can change things, but analyse to see whether the new man or team has the right ideas.

To close with an example: don’t buy Seaworld [SEAS] after the negative surprise of yesterday, at least not yet. ?Analyze for solvency. ?Try to figure out whether the actions management is proposing will actually make things better, or whether the company’s prospects have been permanently reduced.

Don’t try to catch a falling knife. ?Rather, analyze, and if it makes sense when the panic has died down, buy some as a part of a diversified portfolio.

PS — In distress, the real pros look down the capital structure to see whether the preferred stock, junior debt, senior debt, bank loans, or trade claims look attractive. ?That’s beyond the average investor, but in times of distress, those securities trading at a discount may be where the real action is. ?The securities that get hurt but not destroyed will typically control the firm post-bankruptcy.

Full Disclosure: No holdings in any securities mentioned