Bargain-hunters have snapped up shares of bankrupt
, hoping that the latest batch of good news will elevate it from the 50-cents-and-under bin.
president Michael Capellas takes the helm. Rumors swirl that former New York City mayor Rudy Giuliani will assume the chairman post.
Unfortunately, investors who think they're getting Capellas and Rudy for pocket change are making a huge mistake. Chances are, they will end up with nothing.
"WorldCom stock will probably go to zero," said Ben Branch, professor of finance at the University of Massachusetts at Amherst, and co-author of
Bankruptcy Investing: How to Profit from Distressed Companies
. "Under bankruptcy, bondholders and creditors are owed more than the company assets are worth. When they reorganize, they strip away the debt and then turn around and give the new equity to the creditors, freezing out the old shareholders."
Nonetheless, people have bought into WorldCom shares in recent weeks, driving the stock from nine cents, where it sat on Oct. 22, to 29 cents, where it closed Monday's session. Interest in WorldCom stock has always been high, with a daily trading volume of 26.4 million shares. But on Tuesday, more than 150 million shares traded in a stock only available over the counter.
According to a study from Branch and Philip Russel, an assistant professor of finance at Philadelphia University, buying shares in bankrupt companies is an easy way to lose your shirt. From 1984 and 1993, they examined shares in 154 companies in bankruptcy proceedings and discovered that shareholders in 93 of them -- 60% of the total -- ended up with nothing.
"If you bought every bankrupt company's stock the day after it reported bankruptcy and held until the very end," Branch said. "Most got nothing. And those that did, for every dollar invested, they got back something like 63 cents. That's a horrible investment. You could bury your money in the yard and do better than that."
Indeed, but both Branch and
co-author Hugh Ray say that investors are willing to take the chance because few understand how bankruptcy works.
Essentially, a company enters bankruptcy protection and emerges as a completely different company, with the only real similarities being in name and business only. The ownership stakes change based on who is owed the most, so when it comes time to divvy up equity in the new company, shareholders are last in line to get paid.
"First the lawyers get paid, because no one does bankruptcy work for free. Then the taxing authorities, because everyone pay taxes. Then there are U.S. trustee fees. Then secured creditors, who get taken care of on the side. Then the debtor-in-possession lenders who have liens on everything in most cases. Then bondholders get some equity," said Ray, who is head of the bankruptcy practice at Andrews & Kurth. "A lot of investors who think that they understand the game have terminal euphoria."
A bankrupt company can net nifty gains for the original shareholders, but you'd have a better chance of being hit by lightning. In 1977, St. Paul & Pacific Rail Road filed for bankruptcy but while it was reorganizing, the value of the land it held as assets surpassed the amount it held in debt, netting a windfall for the lucky shareholders. "That's extremely rare, however," noted Branch.
If shareholders don't lose everything, they could receive a sliver of equity in the reformed company by way of a massive reverse stock split. This means shareholders could end up with one share for every 100 they held. At 25 cents a share, you're essentially buying a once-bankrupt company at $25 a share -- and that's in the best-case scenario.
"It's usually just a token equity stake," said Chris Stuttard, editor of BankruptcyData.com, a clearinghouse for corporate bankruptcy information. "The last time I can think of it was with
, but that was a prepackaged bankruptcy, which means they prenegotiated their bankruptcy strategy before entering it."
Even the professionals, who have an excellent grasp of bankruptcy and investing, won't touch shares in bankrupt companies. For starters, these companies are usually not worth buying to begin with.
"Based upon my reading, most research indicates that most companies coming out of bankruptcy end up failing anyway," said Joseph Kalinowski, chief investment officer at Ehrenkrantz King Nussbaum. "I prefer to put my money into more promising situations as opposed to a total crapshoot. I save my gambling for Las Vegas."
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