Betting On Bankrupt Stocks: A Good Investment Or Terrible Idea?


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!

But, I’ve noticed a trend of individual investors taking a much more aggressive approach to investing this “free money” by buying bankrupt stocks.

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!

hertz global

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!

chesapeake

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?

  1. 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.
  2. Unsecured Creditors — These are usually holders of unsecured loans, bond holders, the government (for taxes due), and back-pay of employee salaries, etc.
  3. 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.
  4. 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: Cafecredit.com]

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10 thoughts on “Betting On Bankrupt Stocks: A Good Investment Or Terrible Idea?

  • June 20, 2020 at 10:17 PM
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    Yes, Mr Tako! People like to speculate instead of investing their hard-earned money. A profit of 100-200 percent within weeks is too tempting for many.
    A sensible investing technique by putting in a index fund is too boring for many but that is the best strategy we have!!

    Reply
  • June 21, 2020 at 3:19 AM
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    Ha, and gambling is popular too. I wonder how many people took their stimulus check and just went to a casino to blow it. At least that’s a more direct way of getting rid of it.

    Reply
  • June 21, 2020 at 6:36 AM
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    This may not be popular around here but I advocate having some kind of speculation fund. I don’t kid myself and say it’s investing. It’s not. I’m willing to lose 100% of all of the speculation fund. I speculate only on things I understand and have done all of the relevant due diligence. So why do I do it? I like going down the rabbit hole on certain subjects and if I feel the risk to reward is big enough, I pull the trigger. Sometimes it takes me a year or more of research to do it.

    Other than the speculation fund I’m an index fund nerd so it’s all balanced 🙂

    Obviously I wouldn’t “invest’ in bankrupt stocks as the risk is not worth it.

    Reply
  • June 21, 2020 at 7:36 AM
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    I’ve heard that betting on these bankrupt stocks has become pretty popular as of late. When I was stupid (I’m still working my way up from that level!), I bet on GM when the stock was next-to-nothing. That ended up being only a short time before they declared bankruptcy and I lost my investment, which wasn’t really much. Regardless, that was a good kick-in-the-pants to stay away from those investments.

    Reply
  • June 21, 2020 at 12:13 PM
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    I agree with your conclusion. I’m wondering if folks think investing in a start-up is speculation. It’s interesting to me that a lot of level headed folks gambled a while back when they decided to buy individual stock in an electric car company. I understand that it was a calculated risk. After all, 10 years ago the idea of disrupting the car industry seemed like a pretty big gamble. We still don’t know which way it will go, but many of the Tesla stock owners sure love their valuations. Granted, a new startup is different than a bankrupt company but isn’t buying an individual stock still speculation? I guess I’ll never really know as I’m an indexer!

    Reply
  • June 21, 2020 at 9:21 PM
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    I recently shared how I got burned as a young tike in the 08-09 Recession playing in individual stocks. Not a lesson I want to repeat! Broad funds throughout the last several years.

    Nonetheless, it’s fun to watch the fireworks with all the speculating like with Hertz.

    I think it’s helpful to remember that there’s always someone on the other side of the transaction with stocks. What’s that other person know that I don’t?

    Reply
  • June 22, 2020 at 7:39 AM
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    I agree with Backpack Finance’s comment that it can be good to have a speculation part of your fund. I believe that 95%-99% of your investments should be in long term stocks or index funds which is what I do. Most of my money is in visa, amazon, mastercard, united health, etc… I plan on holding these funds for years and really only do an annual checkup on them each January unless I see something happening to be concerned about with the underlying business. However, this is really boring. I find having one stock pick in my portfolio that is a short-term play (usually months for me rather than days or weeks) helps keep me interested in my portfolio. However, I do a lot of research on that stock. I’m usually buying it because the immediate sentiment about either the stock or its sector is down while the long term business outlook I think looks good. I’m not sure I would buy something as speculative as a bankrupt stock. For example, my gamble stock right now is Carnival (CCL). I bought some when it dropped to $11. I only bought a little over a $1000 which is less than 1% of my portfolio. I have pretty much doubled my money, and believe I will probably triple it when this whole pandemic is over with. Whether I make a killing or carnival goes bankrupt, it really doesn’t move the needle on my portfolio either way. So why own it if no matter how it does your overall investment amount doesn’t change much? Because it keeps me interested in my portfolio as a whole.

    Reply
  • June 22, 2020 at 8:12 AM
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    This is why you should start investing early. You gain a lot of experience and learn from your mistakes.
    Lose money a few times early and you’ll stop investing in bankrupt stocks. It’ll be a learning experience. Also, losing money when you’re young probably means a small amount in the long run.
    Do this when you’re young.

    Reply
  • June 22, 2020 at 2:59 PM
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    You might as well going to the casino and put all your number on black. Like you said, that’s not investing, you’re simply speculating. 🙂

    Reply
    • June 22, 2020 at 7:28 PM
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      I think betting on black has much better odds and way better ROI than buying stock in a bankrupt company!

      Reply

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