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How Debt Can Sink Your Investment

In my years as an investor, if I had to point at the single most destructive aspect to an investor's portfolio, I would point to debt. More failures, blowups and capital wipeouts have occurred as a result of debt than for any other reason I can think of. And the losses are not always because an investor employed too much leverage. There's another danger that many investors fall victim to, and the results can be just as horrific.

Rather than taking on their own leverage, many investors do the next worst thing and invest in highly indebted companies. My simple advice to 95% of investors out there is to avoid companies that have too much debt. No ifs, and or buts: Simply stop investing in companies that have too much debt.

While many columns give suggestions on what to invest in, this column will focus on investments you should avoid. Quite frankly, avoiding mistakes is the single most effective way to guarantee a successful outcome. Yesterday's winner of the PGA Championship golf tournament, Rory McIlory, had the fewest number of bogeys all week. He started the tournament with a bogey-free round on Thursday and shot the only bogey-free round on Sunday to win his second major by a commanding eight-stroke margin. Rory avoided the mistakes and found himself in the winner's circle.

If you look back to 2008, the one industry that has been the most decimated to this day is maritime shipping. It's no coincidence that most businesses in this industry have the most levered balance sheets. DryShips (DRYS - Get Report) has long-term debt of $4 billion against total assets of $8 billion, of which $7.5 billion is cargo ships. Five years ago, shares were trading for over $120; today the stock languishes below $3, and I would not be tempted despite the "low" price.

Fast forward to today, and the song remains the same. ATP Oil and Gas (ATPG) has spent the past couple of years stacking its balance with more and leverage. Over the years, I was a big of ATP: it had a great business model, high-quality reserves and a reasonable balance. That all changed over the past couple years, and ATP went from being an investment to a speculative bet in my book.

Unfortunately, it looks like the equity is no play at all anymore: Last week, ATP's shares plunged more than 70% to $0.35 as news surfaced that a bankruptcy filing was imminent. In the past three years, interest expense swelled from $40 million to over $300 million. In the past three years, the stock has plunged from over $15 to penny-stock status today.

Another name to avoid is yet another good business gone bad via debt. I'm talking about Central European Distribution (CEDC), a leading spirits company in Poland and Russia. In fact, CEDC has a No. 1 or No. 2 market share in most of its categories. The company also has $1.3 billion in short-term and long-term debt against $800 million in tangible assets. From a high over $30 back in 2007, shares trade for less than $3.

When you bet on a company that has excessive debt, you are praying for a miracle. Yes, miracles sometimes happen. At the peak of the financial crisis in 2008, shares of retailer Bon-Ton Stores (BONT - Get Report) plunged from over $20 the prior year to nearly $1. Within a manner of months, the Federal Reserve began supplying credit to the economy, Bon-Ton was able to refinance is debt, and shares surged to over $15. Volatility like this attracts some to leverage. Bon-Ton's shares have since fallen back to $7, but the company remains highly levered.

In certain businesses, what appears to be an abnormal amount of debt may make sense. Overall, however, you can have a winning investment portfolio over the long run by simply eliminating the big wipeouts and staying away from excessively indebted businesses.
At the time of publication, Gad had no positions in stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of Gad Capital Management, a value-focused investment firm based in Athens, Ga. Gad has written extensively for The Motley Fool and was a securities analyst for UAS Asset Management, a small value investment fund in New York City, in 2007. From 2002-2005, Gad managed assets for the Gad Investment Group.

Additionally, Gad has just released a new book, The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett. He earned his BBA and MBA at the University of Georgia. Gad appreciates your feedback; click here to send him an email.

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