Chapter 11 Investing Can Produce Results, but the Odds Are Against You

Investing in bankruptcies can yield returns, but it is not certain

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Jul 27, 2017
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There are plenty of stories floating around about investors who have made millions from investing in hidden micro-caps and even bankrupt situations.

Irving Kahn, Walter Schloss and Benjamin Graham, as well as Warren Buffett (Trades, Portfolio), have all made money from these situations - and they are some of the most respected value investors of all time.

While there are huge rewards to be made from investing in these bankrupt situations with an asymmetric risk-reward profile, the chances of you losing everything are significant. For every one successful investment, there are nine losers. That is not an attractive risk-reward ratio at all.

Chapter 11 is no shortcut to success

A research paper published in April 2014 considered the argument for and against investing in bankrupt equities in the hopes of a huge payoff. Titled “Investing in Chapter 11 Stocks: Trading, Value and Performance,” the report found the following:

“[B]etting on these stocks on average generates large losses… Our sample’s median matching-sample-adjusted monthly return is -15%, and market-adjusted monthly return is -14%. The negative abnormal returns do not cluster in a particular year but persist over time. In addition, this finding is…an indication of the poor performance during the Chapter 11 process, which can last from a few months to a few years. It is surprising that investors lose so much money investing in Chapter 11 stocks, even given the fact that shareholders are residual claim holders in bankruptcy. Thus, the finding that Chapter 11 stocks underperform indicates the existence of market frictions. Our explanation for the negative returns is motivated by the Miller (1977) theory, which argues that, when investors have heterogeneous beliefs about the value of a risky asset in a market with restricted short-selling, prices will reflect the more optimistic valuation. After Chapter 11 filings, these stocks are mostly traded on Pink Sheets, which does not require information disclosure to investors. Meanwhile, as the stock ownership data shows, institutional investors dramatically reduce their stock holdings around bankruptcy filings, and more than 90% of the shareholders post-filing are individual investors. Many analysts stop covering these stocks due to the lack of interest from institutional investors. Individual investors are presumably less efficient in gathering information and interpreting the available information (Barber and Odean, 2000). Therefore, the information uncertainty and the divergence of opinion regarding the true value of these stocks increase dramatically after filing. In addition, low institutional ownership produces binding short-sale constraints for these stocks. As a result, the high information uncertainty and binding short sale constraints cause bankrupt stocks to be overvalued.”

These are some fascinating observations because they appear to show that while institutional investors do invest in bankrupt equities, it seems they evacuate the equity tranche of the capital structure.

Instead of holding the equity, which they no doubt perceived to be worthless, institutional investors move up the capital structure, buying instruments with stronger claims over the bankrupt company’s remaining equity.

Key takeaways

The results of this study are significant because they show the extreme disadvantage the average investor has compared to institutional players. Even though the attraction of what may seem to be deeply discounted, near bankruptcy securities may be too difficult to pass up for value investors, institutional investors will always have the upper hand in any bankruptcy situation or reorganization. Yes, there may be the occasional success story, but the chances of you making a 10 times or 20 times return are extremely limited. It is more likely you will be left holding the bag while an institution makes off with any remaining equity.

The above does not just apply to investors who have become involved in the situation because of the bankruptcy. In a situation like SunEdison Inc. (SUNEQ, Financial) or Dryships Inc. (DRYS, Financial), where shareholders have been waiting for a turnaround for years, even if you held before the downfall, institutions will have the upper hand.

Looking for other opportunities will almost certainly offer a better return on investment than wasting time and money hoping a Phoenix will eventually emerge from the ashes.

Disclosure: The author owns no stocks mentioned.