Is the Next MF Global in Your Portfolio?

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For stock market investors, the end of MF Global's (OTC: MFGLQ) run on the public markets was as bad as it gets. The company declared bankruptcy, which basically means that shareholders will lose nearly everything they had invested. Obviously, this is a situation that we Foolish investors would like to avoid.

While the MF Global team at The Motley Fool took an exhaustive look at many aspects of the broker's collapse, one thing we didn't explicitly cover was what warning signs stock investors should look out for to avoid investing in the next MF Global.

This is actually a more difficult exercise than it seems, because with the advantage of hindsight, many pieces of the puzzle look like much bigger red flags than they might have at the time. However, I think just a few big lessons from MF Global's disastrous unraveling can go a long way toward making sure you don't end up with an MF Global in your portfolio.

Leverage kills
For the fiscal year ending in March 2008 -- long before anyone had any clue that former New Jersey Governor Jon Corzine would end up running MF Global -- the broker boasted a total leverage ratio of 39-to-1. By comparison, in Lehman Brothers' May 2008 quarter -- the last set of full financials it filed before declaring bankruptcy -- its leverage was 24-to-1. At MF Global, leverage actually came down under Corzine, but in its final set of financials, the leverage ratio was still at an astounding 30-to-1.

What does this mean? For one thing, it means that there are a lot of lenders who need to get paid before any profits make their way down to shareholders. It also means that there are a lot of folks who have claims on the company and its assets who are senior to stockholders. And, perhaps most concerning, it means that if lenders suddenly get concerned about the stability of the company they can pull funding from the company or refuse to offer new funding (particularly if the loans are short-term in nature). For a debt-heavy company, this is akin to having its oxygen supply cut off.

There are plenty of companies today that set off some alarms when it comes to leverage. Sirius XM Radio (NAS: SIRI) has balance sheet leverage of 36-to-1, SLM (NYS: SLM) is at 41-to-1, and Ciena (NAS: CIEN) clocks in at a whopping 140-to-1. Also, the legacy airlines don't look all that hot with US Airways (NYS: LCC) at 93-to-1, Delta (NYS: DAL) at 48-to-1, and United Continental (NYS: UAL) at 23-to-1.

While none of these stocks are likely to find their way into my portfolio with balance sheets like that, they're not equally concerning to me. Sirius and Ciena are comparatively less worrisome because their debt is largely longer-term. The airlines are slightly more concerning as they have debt that needs to be paid up sooner -- Delta, for example, had nearly $2 billion of current debt on its balance sheet at the end of the September quarter.

SLM is potentially the most worrisome because of the $30 billion in shorter-term debt on its books. To be fair, a lot of those loans are through programs backed by the U.S. Department of Education. That may be enough to set some investors' minds at ease, but this Fool generally prefers safer pastures.

Read the filings
The huge amount of balance sheet leverage that MF Global was employing may have been enough to keep a lot of investors far away. But for those who dug into the company's filings, there were a surprising number of additional red flags at their fingertips.

The annual 10-K filing (which came out back in May), for example, obviously covers the company's financial picture. That alone would have shown investors a company that was unprofitable, highly levered, and posting negative operating cash flow. By reading deeper into the financials, investors could have also seen the heavy amount of MF Global's financing that came through repurchase agreements, which are financing arrangements that often have very short-term durations.

But there was more. In the filing's "risk section" there was a warning that the company would become riskier through the new strategy that Corzine was pursuing. It read, "We also expect that, as we implement our strategic plan, our exposure to market, credit and operational risk will increase as we expand our principal trading activities." It went on further to explain that if financing principal trading positions became difficult, it could lead to big problems:

To the extent such funding and financing resources become too expensive, unavailable or capital intensive, we may be forced to exit prematurely or in adverse market conditions, which could result in substantial losses.

Talk about prophetic.

And if that's not enough, you know that gnarly European sovereign debt repo-to-maturity trade that is widely credited as having sunk MF Global? It was actually pretty clearly outlined in that same annual report. The company laid out the countries whose debt it had purchased (Italy, Spain, Belgium, Portugal, and Ireland), how much it had purchased ($6.3 billion), the risk of increased margin requirements if there were credit downgrades, and the risk associated with having such a large, concentrated position.

Sure, SEC filings may not be the most engrossing reading out there, but for those who want to get the most out of their investments -- and avoid ticking time bombs -- they should be considered required reading.

Watch the flux
A final aspect that should have made investors cautious about MF Global was the amount of change at the company. The CEO and chairman -- Jon Corzine -- had only been at the helm since early 2010. He replaced Bernard Dan, who himself had only been the CEO since late 2008. The COO joined in late 2010, the general counsel came on in 2009, the CFO had just been promoted in 2011, the chief risk officer joined in 2011, and the managing directors of Asia-Pacific and Europe came on in late 2010 and early 2011, respectively. And, of course, the company was undergoing a big strategic shift.

For investors with an appetite for risk, this kind of situation could present opportunity. If those significant uncertainties turn into positives, the investment could pay off in a big way. However, with that much turnover and change within the company -- particularly when that change explicitly involves taking on more risk -- there's ample room for things to go very wrong.

Skip that, grab these
I've been known to rummage through the bargain bin looking for stocks that appear ugly but could pay off in a big way. However, for the bulk of my portfolio, I stick to high-quality, dividend-paying stocks that I can count on to help me get rich slowly over long periods of time. What kind of stocks, you ask? Stocks like the ones in The Motley Fool's special report, "Secure Your Future With 11 Rock-Solid Dividend Stocks." You can grab a free copy of that report by clicking here.

At the time this article was published Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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