Any time a business lays off employees is a bad sign. Most companies that lay off large numbers of workers are heavily dependent upon strong economic activity. For example, appliance, automobile, and furniture manufacturers all lay off employees whenever there is a significant drop in new home sales because that means fewer people have the means to buy expensive durable goods. When consumers once again start buying homes they make other large purchases.
A spike in home equity loans can lead to spikes in some manufacturing industries but not always. When consumer debt becomes too large many people dip into their home equity to pay off credit cards and other high-interest debts (such as signature loans with finance companies). Any manufacturers who are waiting for consumers to reduce their debt loads risk hiring new workers too soon if they speculate on the reasons behind spikes in home equity borrowing.
When large companies experience financial difficulty for a long period of time their stock prices decline. These kinds of stocks are vulnerable to market shorting, where speculators sell stocks at current prices (borrowing the shares to sell from their brokers) and then buy them back later after the stock prices have declined even further. However, before you assume this is easy money, remember that when a company loses money quarter after quarter investors become wary of buying the stock at any price. Hence, some speculators lose money because they cannot sell all the shares they commit to buy.
Laying off employees reduces one of the largest expense sources for most companies: labor costs. Investors often drive up the stock price of a company that announces layoffs because they hope that the management will be able to reduce costs enough to return the business to profitability. However, studies have shown that layoffs rarely push companies back into profitability. Instead, reducing the labor force makes it harder for a company to maintain quality of services and manufacturing, and they may sacrifice capacity for cost savings. Customers may turn their backs on a company that has laid off too many experienced employees.
Layoffs are usually one of the first tasks that new CEOs of companies undertake. They are expected to reduce costs quickly and laying off workers is a quick, easy way to reduce expenses. However, this cheap tactic not only puts people out on the street it ultimately backfires because consumers and business partners become wary of working with companies that are so desperate they lay off employees to please investors.
The temporary spike in a company’s stock price that is driven by layoffs usually falls back down quietly as the company fails to generate new revenues. Hence, making layoffs an early tenure choice is a sign of bad business leadership among CEOs who take over companies that are in financial distress. In some situations the CEOs have no choice. Their predecessors led the businesses so deep into debt that creditors are demanding payments which can only be made by diverting cash flow from payroll to servicing debt.
This temporary infusion of cash into the accounts payable system may buy a CEO enough time to bring about more strategic changes in the company’s business model. Savvy investors look at the CEO’s record of dealing with financial distress in past jobs, if any data are available, and they estimate how much turnaround they can expect from the new leadership. Ultimately laying off employees is just a delaying tactic. If the company cannot generate new sales it will eventually be forced to reduce costs in other ways.
When layoffs become a necessity companies may also reduce costs by closing plants or cutting back on their hours. Even if they own the real estate outright these manufacturing facilities use a lot of energy and require large maintenance staffs. Closing the facilities or cutting back on production usually means the companies reduce utility expenses in addition to labor costs. They may also be able to pay less for insurance because no one is using their equipment and facilities.
If a company rents many storefronts or office locations then employee layoffs may be accompanied by retail or office closures, thus reducing expenses further. One way this strategy helps companies is when they close down unprofitable locations. If a company is able to pare down its money-losing operations then it can return to profitability merely by operating only at locations where it makes sense. These kinds of layoffs, although painful to the workers and their communities, often produce good long-term results, although other poor decisions may offset those benefits.
For example, JC Penney & Co. hired Ron Johnson from Apple, Inc. to be its CEO in 2011. Johnson decided that the old retail store needed to change its business model. He did away with sales events and began remodeling Penney’s large stores to adopt a new boutique model. Unfortunately JC Penney’s once-loyal customers hated these changes and they began shopping elsewhere. The decline in sales forced the company to close stores and lay off employees. In 2013 the company’s board of directors fired Johnson and replaced him with a “temporary” CEO.
When a large company like JC Penneys stumbles so badly in long-term strategy the inevitable reduction in staff and locations becomes the only way for a new CEO to buy time as cash reserves dwindle. These kinds of companies are not necessarily good investments even though their stock prices may temporarily improve. The rise in prices means that investors are dumping shares on the market to reduce their risk of exposure to more corporate losses. Whomever is buying those dumped shares may be hoping that the company liquidates assets or subsidiaries and spreads some cash around, either directly to investors or in terms of making new acquisitions.
Simply buying a temporarily popular stock in a distressed company is a poor investment strategy. You need to look at what the company’s leadership is most likely to do and how that may play out. In the end you either have to bank on a liquidation, in which case the company may radically alter its business model and return some cash to investors; or you have to hope that the company will build new growth. Liquidation may also lead to a merger or buyout. If a company is so distressed it cannot survive on its own, selling itself to a competitor may be the only way to preserve at least some of the assets and jobs it once provided.
If you cannot afford to lose your investments, putting money into distressed companies is probably not a good idea. Most investors will never be able to buy enough stock to have any real say in how a distressed company is managed.