Investors put their cash in the market in order to make more money, not lose it. So it can be befuddling, then, that some people are interested in bankruptcy investing—or, buying stock in Chapter 11 (bankrupt!) companies.
However, bankruptcy investing is a type of investment that may appeal to some, but it’s a high-risk strategy that may not be the best route for most investors. In this piece, we’ll go over bankruptcy investing, and why investors might be interested in buying stock in Chapter 11 companies.
Different Types of Bankruptcy
First, we’ll need to talk about the key types of bankruptcy, which is a complex, legal process that companies, municipalities, and individuals undergo when they’re unable to pay their debts. It’s important to know that just because a company declares bankruptcy doesn’t mean that it’s no longer an operating business. There are six different types of bankruptcy, known as chapters, with Chapters 7 and 11 applying to businesses.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy means that a company is ceasing operations and liquidating its assets. If a company declares Chapter 7 bankruptcy, assets are sold off for cash, and used to pay off its debts in an order determined by bankruptcy laws. Often investment bankers head the valuation process and help companies sell various assets during the bankruptcy process.
Then, bondholders and investors get their share of any asset left. When all is said and done, the company will no longer exist, and any assets it had will have new owners.
Chapter 11 Bankruptcy
Chapter 11 bankruptcy, or “reorganization,” is different from Chapter 7. Companies often file for Chapter 11 bankruptcy as a defensive move when their debt payments become untenable.
Under Chapter 11 protections, companies focus on restructuring and getting their debt under control, increasing revenues, and cutting costs. During the bankruptcy reorganization companies can often renegotiate interest rates or eliminate some debt payments entirely.
These companies are basically calling a time-out so that they can revise their gameplan. Companies often keep operating under Chapter 11 bankruptcy. Ultimately, the goal is to use Chapter 11 protections to buy some time, put together a plan to emerge from bankruptcy, and return to profitability.
What Happens To Stock When A Company Goes Bankrupt?
Under Chapter 7 bankruptcy, investors’ shares are effectively dead, since the company is going out of business.
If a company files for Chapter 11 bankruptcy protection, a few things could happen. Shares could continue trading as normal, with little or no effect (other than price fluctuations) for investors. The stock may get delisted from major stock exchanges, but can still be traded over-the-counter (OTC). But be aware: The company may also cancel shares, making some investors’ holdings worthless.
Why Invest in a Bankrupt Company?
A company declaring bankruptcy sends a pretty clear message to investors that it’s in trouble, which can cause share prices to fall. For some investors, falling prices present an opportunity to buy—an attractive one, especially if they believe that those companies will return to profitability in the future.
At its core, bankruptcy investing is all about perceived opportunity. Many large companies with recognizable names have declared bankruptcy in recent years (examples include GNC, Hertz, Gold’s Gym, JCPenney, and Pier 1 Imports), and buying big-name stocks at rock-bottom prices can be very appetizing to investors.
There’s a chance that these companies can and will emerge from bankruptcy with streamlined operations that can quickly start driving revenue, causing share prices to increase in value. But it’s also possible that a bankrupt company is too far gone, and won’t be able to return to profitability. Investing in bankrupt companies is speculative and risky, but the potential of big rewards is enticing to some investors.
Research to Do Before Investing in Bankrupt Companies
When investing in any stock (not just bankruptcy companies), it’s important to do your research, or due diligence on the company. For many investors, that means doing more than just looking at the price fluctuations over the past few days—it involves digging into the nitty-gritty details. Often, those processes can include fundamental and technical analyses.
Fundamental analysis of stocks involves taking a look at, well, the fundamentals of a company. That could include evaluating a company’s profits and growth, or metrics like earnings per share or cash flow. Investors are generally looking for strong companies to invest in, and generally, analyzing a company’s performance will give a sense as to whether or not it’s worth investing in.
Stock technical analysis, on the other hand, is a little more…technical. It involves looking at a stock’s patterns and trends in order to try and predict what it will do next. Essentially, it’s a method of forecasting a stock’s future performance based on its historical performance.
Recommended: 5 Ways to Analyze A Stock
Of course, if a company is bankrupt, both fundamental and technical analyses will likely provide some less-than-inspiring data, such as an unsustainably high leverage ratio. These companies have gone bankrupt, after all—so, investing in a bankrupt company will also require a leap of faith and research into their industry and their plan to return to profitability.
The Takeaway
Investing in bankrupt companies is a risky endeavor, but it holds the potential for sizable rewards. That said, bankruptcy investing is something that many investors take part in, even if it’s not the cornerstone of their investing strategy.
One way that intrepid, active investors may be able to make some money off of bankrupt stocks is through day trading. While a bankrupt company’s stock may not perform well over time, its value will fluctuate day-to-day, opening up potential opportunities to scrape some positive returns. A positive news story about a bankrupt company may cause a stock’s value to shoot up one day, only to fall the next, for instance, or it could spike in a market rally.
Of course day trading also holds a variety of investment risks and is typically not the best strategy for long-term investors or those with a low appetite for risk. No matter your strategy, the SoFi Invest® brokerage platform is an easy way to start building your portfolio.
Photo credit: iStock/Rocco-Herrmann
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