Secret Hiding Places: Opportunities After Bankruptcies

For careful investors, look at new stocks coming out after bankruptcies are complete

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Apr 09, 2019
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The word “bankruptcy” has the ring of fatal failure, and often that is the case for shareholders in companies that slip that far.

But Joel Greenblatt (Trades, Portfolio) also reminded us in chapter five of “You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits” that there can also be opportunities after bankruptcy proceedings are over. He wrote, “The corner of the investment world occupied by companies at some stage of the bankruptcy process is filled with opportunities—and land mines.”

There are many reasons for companies to reach bankruptcy court, including:

  • Bad management.
  • Overexpansion.
  • Government regulations.
  • Product liability.
  • Changing industry conditions.

Companies that fail for those reasons often are not very good companies, but there are cases in which a good company can be taken down by overly optimistic forecasts or too much debt. According to Greenblatt, “It is these attractive but overleveraged situations that create the most interesting investment opportunities.”

But don’t buy them after the company files for bankruptcy. Yes, the prices will be cheap, but there is a reason and that is that shareholders are the last in line for what remains: after employees, banks, bondholders, suppliers and the tax man. This usually means there are only pennies per dollar left by the time shareholders get their share.

While stocks should be ruled out at this stage, there are other possibilities for adventurous investors, including bonds, senior secured bonds, zero bonds and even bank debt. But these are areas best left to specialist firms that deal with these situations every day. Among them are the so-called “vulture” investors.

For regular investors, though, it is best to wait until the bankruptcy process has been completed and all the difficult issues have been sorted out. When a newly revived company emerges out of bankruptcy and wants to sell shares again, it must issue a detailed disclosure statement. It will be more comprehensive than a regular stock offering because it must also account for the previous failures and workouts.

As with spinoffs, merger securities and other special situations, stocks emerging out of bankruptcies are often deeply discounted. Most individuals and institutional investors who receive them sell them as soon as they can, for various reasons.

The challenge for those who want to take advantage of the bargains is to distinguish between the weak and strong companies that successfully emerge from bankruptcies. Greenblatt suggested there might be good opportunities in a company that went under because it paid too much for a takeover or leveraged buyout. There are also companies that had short-term problems and too much debt to stay afloat while those problems were resolved. Then there are companies that go into bankruptcy to protect themselves from product liability lawsuits.

Other companies with potential include those with strong market niches, brand names, franchises or enviable industry positions. Greenblatt offered the example of Charter Medical Corp., now Magellan Health (MGLN, Financial). The company’s main business was operating a chain of 78 psychiatric hospitals and got into trouble after a management-led, leveraged takeover in 1988.

After emerging from bankruptcy in 1992, Charter’s shares were selling for slightly more than $7, likely because the debt load was still substantial despite being reduced through bankruptcy proceedings. From Greenblatt’s perspective, that debt also provided strong upside leverage. The stock was also attractive because insiders still held significant positions.

Getting back to the share price, Greenblatt calculated that with the valuations of comparable hospital chains, Charter should be selling for about $15, not $7. In his mind, it was a “huge price discrepancy.” He was also impressed that in the following year, the company contained its costs, increased patient admissions and sold off its conventional hospitals at a fair price. To top it all off, Wall Street analysts and observers began to take notice of it again, leading to increasing popularity among other investors.

As a result of all those elements, the share price tripled in a year and Greenblatt reported a large gain. Had he remained a shareholder, however, he would have been disappointed; in the three years that followed the company’s upturn stalled, leaving its share price largely flat.

On that note, the author offered a short lesson on when investors should sell stocks. Buying, he noted, is much easier than selling. There are significant signals or triggers that indicate when it’s time to buy—low prices, limited downside and more—but few comparable signals indicating it’s time to sell.

He put it this way, “When do you sell? The short answer is—I don’t know. I do, however, have a few tips.”

One of those tips involves awareness of the event that occurred, the event that led to the buying opportunity after bankruptcy proceedings were over. If the market, the crowd or the herd becomes aware of the change that has occurred and beings buying, your edge is lessened and it might be a rational idea to sell.

Selling might also be triggered by a “substantial” increase or decrease in the share price because the fundamentals have changed. Perhaps its earnings or cash flow have changed direction.

Turning to the timing of a sale, Greenblatt offered this tip: “Trade the bad ones, invest in the good ones. No, this isn’t meant to be as useless as Will Rogers’s well-known advice: 'Buy it and when it goes up, sell it. If it doesn’t go up—don’t buy it.' What 'trade the bad, invest in the good' means is, when you make a bargain purchase, determine what kind of company you’re buying.”

More specifically, if you bought an average company because you saw a short-term opportunity, sell once the stock becomes more widely known. This, for example, was his rationale for selling Charter Medical; it was improving but was still not an exceptional company.

Different example, a different choice: Greenblatt bought American Express (AXP, Financial) shares after it had spun off Lehman Brothers. The latter was an unpredictable business that overshadowed the attractiveness of the credit card and financial service businesses. The new, trimmer American Express looked like an attractive business, so he held on to its shares for the longer term.

For investors with a value bent, buying stock after a corporate bankruptcy can generate profits. They must research their decisions very carefully, however, to determine whether to buy in the first place and to determine how long they should stay if they take a position.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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