Imagine for a moment that you’re stuck at home. There’s no sports, no concerts, no festivals, no new movies, and the federal government (in all its infinite wisdom) has decided to write you a check! Woohoo! Free money!
But what could you do possibly do with that money? Assuming you’re one of the lucky folks that still has a job, you might elect to spend that money on consumer goods. People in more dire straights might use it to pay rent, or buy food.
But there are other options to consider. Since this is “mad money”, you might instead elect to invest that money into the stock market… Why not make a few extra bucks betting on stocks courtesy of Uncle Sam? After all, when the tide rises it tends to lift all boats!
You might be surprised to learn this imaginary scenario isn’t actually that far from the truth. Real people with excess cash are doing this exact thing — investing their COVID stimulus money.
Sensible people might elect to invest in an index fund and then call it a day. Nothing wrong with an index fund. It’s a perfectly OK way to invest spare cash!
As a class, they’re some of the most volatile stocks in the market!
What Are Bankrupt Stocks?
Bankrupt stocks (as you might guess) are publicly traded stocks that have recently filed for bankruptcy (usually Chapter 11 bankruptcy). For one reason or another, these companies are unable to meet financial obligations with either cash flow from the business or debt restructuring.
Even though these companies are going through bankruptcy proceedings, the shares do not get delisted from the stock market. Meaning, individual investors can still elect to buy and sell shares even though the corporation doesn’t have the necessary cash flow to pay back creditors.
Couple a bankrupt stock with zero dollar trades at many brokerage houses, and these are ideal circumstances to create incredible stock volatility. Bankrupt stocks like Hertz (Symbol: HTZ), J.C. Penny (Symbol: JCP), Whiting Petroleum (Symbol: WTT)and Pier 1 (Symbol: PIRRQ) have all seen stock price increases by an average of 47% in recent weeks.
Hertz, the beleaguered rental car company, saw its stock price move from $1 to $5 dollars in a single week, and then back down again. That’s crazy town!
Even nearly bankrupt stocks, like Chesapeake Energy (Symbol: CHK) saw very similar price movements. Chesapeake Energy’s stock price quadrupled during this same week in June!
Wow! What exactly is going on here? Are these companies actually good investments? Or, have these companies simply become part of a “momentum trade” for folks looking to make quick profits from penny stocks?
Good Investment Or Bad Idea?
Simply put, bankrupt stocks are terrible investments. If you hold a bankrupt stock long enough, the value of your holdings is almost certainly going to go to zero.
Why does this happen?
To understand why bankrupt stocks are usually worthless, you need to understand a little bit about how value is distributed or rather *redistributed* in the event of a bankruptcy. Just like mathematical equations, there’s an order of operations where those who are “owed” get their pound of flesh.
What exactly is that order?
- Secured Creditors — Typically these creditors hold banks loans contractually secured by real physical assets (real estate, inventory, machinery, etc). These creditors are considered the most ‘senior’ and are the most likely to see any value from a bankruptcy.
- Unsecured Creditors — These are usually holders of unsecured loans, bond holders, the government (for taxes due), and back-pay of employee salaries, etc.
- Preferred Shareholders — Preferred shares are typically senior to regular shares. Preferred shares are a hybrid of debt and equity, which I’ve discussed in a prior post.
- Common Stock Holders — Regular common shareholders. Common stock holders are considered the ‘owners’ of a stock, but are the most junior of creditors.
That’s right — regular shareholders come dead last during bankruptcy proceedings.
In the event of a business liquidation (Chapter 7), shareholders commonly get nothing (or next to nothing). In the case of a Chapter 11 reorganization, the business might still continue to be a viable business, but senior creditors will usually become the new owners of the business. New shares are commonly issued to creditors (according to the order of operations), and the old shareholders get watered down to mere pennies on the dollar….
Which absolutely sucks if you’re a shareholder. You don’t want to be riding one of these stocks to zero!
This little factoid hasn’t stopped momentum traders from buying shares in recent weeks however. Bankrupt stocks have essentially become trading vehicles for speculators who attempt to capture the incredible volatility of the stock market in recent weeks.
Invest, Don’t Speculate
To put this another way, the buying of bankrupt stocks is pure speculation. These stock have no underlying asset value for the investor. He or she is simply subscribing to the greater fool theory — buying shares hoping to find a ‘greater fool’ in which to sell the stock.
Don’t be a fool. This is NOT investing.
Remember: For every trader who boasts on Twitter about his ‘win’ day-trading in bankrupt stocks, there’s always a loser on the other side. Someone who got stuck holding the bag with no ‘greater fool’ with which to sell.
Consider this post a warning — Bankrupt stocks are dangerous territory, and not a place for the average person to put money. Even if it’s just stimulus money you can afford to lose.
Investing in bankrupt stocks might be all the rage in certain circles, but in my humble opinion, speculating on bankrupt stocks is no different than buying a lottery ticket or putting your money on black in Vegas. It’s gambling.
Given a long enough time horizon you’re bound to lose on bankrupt stocks.
Be careful out there!
[Image Credit: Flickr1]