Hi friends. This week, I’ll share a back and forth with a friend who wrote me from Nigeria with a good question concerning investing in stocks of companies with negative equity on the balance sheet. The quoted portion of this post today can also be found in the commentary to one of my blog posts at this website from the fall of 2014.

He writes:

“what is your take on companies with negative equity? will you invest in a company that met your other requirements but carry negative equity? It’s like many companies are deliberately carrying negative equity these days.”

This comment about deliberately carrying negative equity is not only interesting but probably very true and relevant. Indeed there are a host of some very large brand-name companies we could list here that have a significant negative equity balance today.

My response was as follows:

“You are correct in saying that there are companies with negative equity that meet the criteria except the P/B. I personally don’t want to invest in companies with negative equity. Liabilities exceeding assets is the definition of insolvency. I agree with you about the company intentions too. Many large companies choose to take on negative equity (usually having substantial debt on the balance sheet) to keep pushing the leverage envelope to push stock price higher and higher. Leverage can expand operations and it can accomplish stock buybacks and these things can produce a higher eps. But the music could stop suddenly too with a major macro travesty. So long as interest on the debt is paid timely, lenders tend to be willing to roll over the principal to where the levered companies don’t ever really settle the debt. To me, I’m a simpleton meaning I’m risk averse and negative equity means a company with more obligations than it has in resources.”

I appreciated this comment/question. It seems we live in times where, on many levels, we really don’t believe debt (principal) actually comes due. As to negative equity, it’s plausible that assets are understated at book value to the degree that the company actually has the ability to settle all obligations today. However, if that’s not the case, it seems to me a willingness to invest in negative equity implies a belief that the company can easily resolve its asset shortfall via future income generation, new equity issuance, etc., OR it may suggest that one has such strong confidence in the company’s continuing operating success so as to assume its lenders will not require principal (full payment) when maturity is at hand. That, is new replacement debt will virtually make debt settlement a non-event.