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Alert! How investors can avoid the next Thomas Cook-style wipeout

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The collapse of Thomas Cook (LSE: TCG) is a reminder that investors can suffer a permanent loss of capital on stocks. Can such disasters be avoided?

As is often the case, a combination of debt and a deterioration of trading did for Thomas Cook. Now, most companies have debt, and deciding whether it’s at a dangerous level and assessing the trading outlook are more art than science.

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Deterioration

Going back to last year, not all writers here at the Motley Fool were of the same view on the prospects of Thomas Cook. On one hand there was an argument that the “level of reward is certainly worth the risk,” and on the other, “with debt up sharply and an uncertain outlook,” the stock was one to avoid.

However — and unusually given the number and diversity of Foolish writers — we’ve been uniformly negative on Thomas Cook all this year. And the negativity became louder and more frequently stated as time went on.

Regularly reading the Motley Fool might help you avoid the next Thomas Cook-style wipeout, but you may be interested in the three factors that informed my own escalating negativity on the stock. I call them the Deadly Triad.

Short sellers

Short sellers of a stock profit if its price falls. I always keep an eye on short positions in stocks via shorttracker.co.uk. There were no disclosable short positions in Thomas Cook early this year, but they increased rapidly over the months, latterly making it the most shorted stock on the London market. Such a rise in short positions should ring alarm bells with investors.

Debt market

In addition to bank borrowings, many companies with debt have corporate bonds that are publicly traded. In Thomas Cook’s case, these began to trade at a significant discount to their face value towards the end of last year and dived below 50 cents in the euro in mid-May. When the debt market is pricing in such a loss on the bonds (which rank above equity), the equity is likely to end up worthless or of purely negligible value at best. Plummeting bond values are another thing that should ring alarm bells with investors.

Shareholders and stakeholders

The completion of the Deadly Triad in Thomas Cook’s case came in a statement from the company on 10 June. Up until this point, the directors had talked of maximising value for “shareholders”. The announcement on 10 June referred to “maximising value for all its stakeholders.” (My bold.) It’s a subtle change of terminology, but you can take it as code for the situation has deteriorated to such an extent that shareholders are no longer the primary focus of the directors’ fiduciary obligations. All the alarm bells in the world should be ringing with investors when a company gets to this stage. In the case of Thomas Cook, its shares were trading at around 18p at the time.

Foolish bottom line

In an article about Sirius Minerals, my colleague Alan Oscroft suggested it’s a big mistake for shareholders to think “there’s no point selling at such a big loss” and “they’re so low they’re not worth selling now.” I agree with Alan. If you think the evidence points to the equity having zero or negligible value, it’s better to salvage what capital you can, while you can.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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