Bankruptcy! Buy, Hold, or Sell?
We’ve reached a breaking point in lockdown where mega-corps can go no longer. The debt-laden and leveraged are starting to fall; Hertz, Latam, J Crew, and these sadly won’t be the last, so what should investors know about trading around bankruptcies?
You’ve probably heard of ‘chapter 7’ or companies going into ‘administration.’ It’s when a company ends things for good and has to search the wreckage for money to repay a pecking order of upset investors. It involves a fire sales of assets, a liquidation, and the proceeds get paid out in the following order;
1 | Secured lenders | The bond investors with fixed claims on specific assets in the business. They can even take a company into bankruptcy themselves if they deem it has tripped a covenant (a risk condition). |
2 | Preferred creditors | The unpaid employees. |
3 | Unsecured lenders | The bond investors with no fixed claims; and include even suppliers and customers. |
4 | Preferred shareholders | The investors paying extra for some priority. |
5 | Common shareholders | The masses – most of us; plum last! We would’ve captured all the upside if the business did well. |
There’s often not enough in liquidated asset value to make everyone whole, so the common stock ends up being worth nothing. It’s customary for shares to delist before this becomes clear, as there are exchange requirements that go unmet. If there’s still a claim on any assets, it’ll be paid to you via a dividend.
I’m bagholding a bust stock, should I sell?
It might be for the best. Many companies today have intangible assets that you can’t touch, like brand power. Brand power carries no liquidation value to spread between investors, so shares probably aren’t worth much of anything. If someone offers you a market price for something that isn’t worth much of anything, take it!
On rare occasions, however, a business still has a spark of life left in it. Take Latam, for example, South America’s big airline. It just went broke buried underneath eight-billion-dollars’ worth of secured and unsecured debt, trading at a price on the bond market that suggests none of it will be repaid. But the stock still isn’t at zero (even though some feel it should be).
There’s been talk about Latam coming back after ‘chapter 11’ restructuring. It’s taken on even more debt, this time super-senior debtor-in-possession financing to give it some cushion cash to keep operating. Investors are lawyering up to argue what the airline is worth, and what amount of debt it could manage, which will be reissued to debtors as per the hierarchy.
Obviously, Latam won’t be able to manage all its former debt, but because it’s gonna keep flying, it may one day be able to make some money, and therefore its equity could be rebuilt. It makes sense to relist one day with new shares, which will go to out-of-pocket debtors. If debtors are still left out-of-pocket, there won’t be any new stock for investors in the old.
It must be easy money shorting stocks that are in ‘chapter 7’ bankruptcy?
No, because yes. In real life, it’s tough to short insolvencies because it’s such a crowded trade; everyone wants to do it, so the borrowing costs are really high. Aston Martin Lagonda was a disaster last year, swarmed by short-sellers, so even at twenty times today’s market price you’d have been set back twenty percent in performance due to the massive costs.
Is there ever a reason to buy a bankrupt stock?
Sure! The famous deep value investing strategy is all about reading these situations. It can often be that companies get last-minute lifelines, founding families reach into their pockets to make things right, or suppliers want to keep their struggling customers in business. There can be so much pessimism that sometimes stocks trade for less than scrap value!
How do bankruptcies work on Fantasy Finance, then?
Invstr aims to run things parallel with the real world, so a bankrupt business disappears from Invstr at the same time that it gets delisted by an exchange. If it’s chapter 11 and things technically aren’t over, we’ll still close your position at a final trading price and return the money to your cash balance. It sucks when stocks go sour, but dust yourself down and come back stronger!
