A credit crisis. A volatile stock market. A projected wave of corporate bankruptcies. To most people it sounds like hell. But for investors who specialize in distressed assets it's just the opposite. "Bear markets are often when these guys plant the seeds for their next big winners," says Chris Mayer, editor of Capital & Crisis, a newsletter that focuses on contrarian investments.
Such scavengers scour the market for stocks, bonds, or whole companies to buy on the cheap, paying less than they think the company's assets are worth. A subspecies, known as vulture investors, aims even lower. These investors pick at carcasses of companies in or approaching bankruptcy, often amassing sizable stakes in order to wield influence in a restructuring or liquidation.
While some of these high-risk investments fail, others can be "monster home runs," says Mayer. His favorite "deep value" players—chiefs of little-known companies such as Leucadia National (LUK) and Brookfield Asset Management (BAM)—boast average annual returns of 15% or more over the past 10 years.
The most obvious way to get into the action is to buy a value-oriented mutual fund (tables). A more rewarding approach may be to invest in companies such as Leucadia. Like Berkshire Hathaway, these are publicly traded holding companies run by managers with histories of sniffing out value. Yes, the risks are more concentrated. But returns, on average, exceed those of the typical value fund over the past decade. Patience is crucial, since returns can fluctuate unpredictably, rising in years when managers sell profitable investments and stagnating when they hold a lot of cash.
Because of the stock market sell-off, share prices of many of these players are cheap vs. historic norms. And after largely sitting on the sidelines during the bull market, many of the companies are flush with cash. They are positioned to take advantage of lower stock prices as well as a projected spike in the default rate for U.S. speculative grade bonds. BusinessWeek's guide to leading publicly traded value players is a good place to start your research.
LEUCADIA NATIONAL
New York-based Leucadia owns everything from a biopharmaceutical company to wineries to a 38% stake in Light & Power Holdings of Barbados. Once weighted toward insurance, the company's portfolio now tilts toward natural resources, including Australian iron ore producer Fortescue Metals Group and Goober Drilling, a Stillwater (Okla.) oil-and-gas concern.
Chairman Ian Cumming and President Joseph Steinberg practice "the epitome of distressed investing," says Steven Rogé, whose Rogé Partners (ROGEX) and Rogé Select Opportunities (RSOFX) funds are shareholders. After Hurricane Katrina nearly destroyed the Hard Rock Hotel & Casino Biloxi, Miss., in 2005, for example, Leucadia bought about half of parent Premier Entertainment Biloxi. In 2001, with Berkshire Hathaway (BRK), it purchased half of bankrupt financial-services company Finova Group. More recently it bought some 25% of subprime auto lender AmeriCredit.
Cumming and Steinberg are often compared to Warren Buffett—and not just for their strict value approach to investing. Like the Oracle of Omaha, the two write engaging letters to investors. "Shareholders who gamble are encouraged to come visit the [Hard Rock Hotel & Casino Biloxi] and leave some money behind!" the most recent one reads. "As always, the odds favor the house, but in this case you own the house." Also like Buffett, Cumming and Steinberg tend to be shareholder-friendly. In 2006 each earned a relatively modest $678,362, in addition to stock-based compensation linked to Leucadia's performance. Between the two, they own some 25% of outstanding shares.