A Double-Edged Trade

 | Dec 14, 2012 | 3:00 PM EST  | Comments
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In the aftermath of Thursday's column on the gut-wrenching ride and wild profit opportunities in foreign banks, I spent some time dwelling on other types of investments with similar risk-to-reward characteristics. These situations are not for everyone, but traders who are more aggressive should definitely consider them. If I was 25 again, these longshot, aggressive, high-risk trades with enormous potential rewards are the only thing I would do with my money. The math of a portfolio of potential asymmetrical payoffs is very compelling, but you have to have a strong stomach and almost inhuman discipline to trade stock with this approach.

One such segment of the market is what I call stub stocks. My definition is a little different from the traditional definition as I included all heavily leveraged companies that have very little equity. I don't care if it was a recap, spinoff or just debt-addicted management that caused the condition. These perform like publicly traded leveraged buyouts. If management is able to grow profits and cash flow, debt are paid down over time and the equity value soars. If your batting average is anything close to .500, you can make a fortune with these stocks.

One such is Casella Waste Systems (CWST). The company has been around since 1975 and went public in 1997. It provides waste collection and management services in the eastern U.S. It owns 10 landfills, 29 transfer stations, 17 recycling centers and 31 liquid and solid waste collection divisions. Garbage is a great business, as it is generated every day and the collection and disposal of it is an ongoing, eternal process. There is some economic sensitivity, however, as a weak economy reduces the amount of trash and limits large collection projects from construction, oil drilling and infrastructure projects. Exactly these conditions have weighed on Casella's operations and they have now lost money for five straight quarters.

There are potential positives that could drive the stock price substantially higher over the next few years. The company has four landfills in New York and Pennsylvania that take drilling waste from Marcellus Shale projects. Casella is involved in a joint venture to recycle water used in the fracking process using a special process that is actually powered by landfill gases. It is also involved in biofuel and other reusable and renewable projects that could provide growth opportunities for the company. It has made some add on acquisitions that have expanded service areas in the past year.

To say the company is leveraged is something of an understatement. It has $637 million of total debt and liabilities with just $32 million of shareholder equity. Interest expense eats up close to 10% of annual revenues. Numbers like these might make some old-fashioned leveraged buyout guys blush. But if the economy picks up, the company should be able to generate sufficient cash flow to handle the expense and even pay down the debt load. If they are successful in doing this, the stock could easily move out of the single digits over the next few years.

H&E Equipment Services (HEES) is another highly leveraged company that could lead to huge profits when the economy recovers. The company rents heavy duty construction equipment, including cranes, earth-moving equipment and aerial platforms. It is seeing slow but steady improvement in business with an 11% year over year revenue increase in the third quarter on the heels of a 13% increase in the second quarter. H&E also refinanced some debt to lower interest costs and improve balance-sheet liquidity. It used part of the refinancing proceeds to pay a special dividend of $7 a share. The debt offering took total long-term debt to more than $660 million from $268 million. H&E only has $37 million of capital so it is now leveraged at more than 15x. It is a huge bet on the future, but if the economy picks up and commercial construction continues to improve this stock could easily see its equity value double in a few years.

This type of investment is not for everyone. As the old saying goes, leverage is a double-edged sword. If the economy doesn't pick up, both of these companies could struggle and face reorganization or even bankruptcy. But if the economy does pick up, the leverage could work in your favor and earn returns that that would rival the heyday of leveraged buyouts.

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