By
Because these companies are multinational conglomerates, there's a high probability that management will rectify current problems and a low likelihood that the company will go belly-up. When the turnaround occurs, these out-of-favor companies will again become darlings of Wall Street, rewarding investors who bought them when share prices were depressed.
People looking to make quick bucks sometimes use this logic to identify other troubled companies, like those in bankruptcy, under the misguided belief that it is easy for management to turn a suffering company back toward the road of profitability. It's not. It's only easy to be suckered into believing this -- especially when Internet message boards and chat rooms are filled with hype about the megabucks to be made via investing in bankrupt companies.
A company in bankruptcy is in deep trouble, not the kind of temporary turmoil that might befall one of the solid Dow heavyweights. Foolish investors look for growth potential; a company in bankruptcy has miles to go before it can put "growth" back into its vocabulary. It's important not to let the memory of the prices a company once attained to seduce you into thinking the company will necessarily see those prices again.
What exactly is bankruptcy?
Bankruptcy is a state of insolvency, meaning a company is unable to pay its debts. Companies have two bankruptcy options from which to choose. Under Chapter 7, liquidation, the company stops all operations and goes completely out of business. A trustee is appointed to liquidate the company's assets and the money is used to pay off the debt. In plain German, the company goes kaput.
The more common choice is Chapter 11, a reorganization, where management continues to run the day-to-day business operations, but all significant business decisions must be approved by the bankruptcy court until the company is solvent again.
Why do firms go bankrupt? Perhaps they've run out of cash. Or the cash they have available won't cover their bills. By selecting a Chapter 11 bankruptcy, companies seek a corporate time out -- they keep their creditors at bay, while existing or new management reorganizes the operation and tries to restore cash flow.
On the surface, investors might see the potential for reorganization and erroneously think it's a decent way to make a quick return on a buck. Unfortunately, investors will most likely wind up losing their hard-earned dollars. Chapter 11 reorganizations can turn into Chapter 7 liquidations if the reorganization strategy fails, or they can limp along for years barely keeping their heads above water.
Understanding how a Chapter 11 bankruptcy is structured can help you avoid being suckered into yet another get-rich-quick scheme that will lead your investing dollars astray. First, the court usually appoints a trustee. The trustee then appoints various creditor's committees, one for each class of debt. The common shareholder (you!) is an owner, not a creditor, which means you have no voice in anything.
The general order of repayment of overdue debts is (1) senior secured debt (funds borrowed from financial institutions, first mortgages or bonds); (2) senior subordinated debt; (3) junior debt; and (4) preferred stock. In a liquidation, shareholders form a fifth class. If any class above your class gets less than 100% of what it is owed, which is likely since the company can't pay its debts, your class gets ZERO. Not a pleasant scenario.
While some bankrupt companies, like Ames Department Stores <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMES)") else Response.Write("(Nasdaq: AMES)") end if %>, have indeed turned around and benefited shareholders, it can be a long and rocky road. (If I want a rocky road, I'm gonna stick to the ice cream.)
In response to last week's column on penny stocks, someone asked for some data backing up my claims that they're no good, they're no good, they're no good, baby, they're no good! Here are some figures from the Better Business Bureau of Eastern Massachusetts, Maine, and Vermont:
"Penny stock swindles are now the number 1 threat of fraud and abuse facing small investors in the United States. A September 1989 report by the North American Securities Administrators Association (NASAA) to the U.S. House Telecommunications and Finance Subcommittee estimates that Americans lose at least $2 billion each year as a result of schemes involving penny stocks -- the shadowy netherworld of the U.S. equity markets. NASAA found that the penny stock industry increasingly is dominated by utterly worthless or highly dubious securities offerings that are systematically manipulated by repeat offenders of state and federal securities laws and other felons, some of whom have been identified as having ties to organized crime."
The report also states that "unmanipulated penny stock investors are believed to lose all or some of their investment 70 percent of the time and the presence of fraud pushes up that figure to 90 percent."
A shadowy netherworld dominated by utterly worthless securities offerings. Ugh. This report is 11 years old and was produced before the Internet gave penny stock hypesters a new and powerful entry into manipulation. I shudder to think what the numbers would look like now.
Stay Foolish!