Monday, 27 March, 2006

Losing money for fun and ... profit?

One of my friends the other day suggested a wonderful new way to get rich quick lose money in the stock market:  buy stock in bankrupt companies that you think will emerge successfully.  On the face if it, it sounds like a great idea:  buy the stock of a formerly high-flying company for pennies on the dollar and hold onto it until the dust settles.  Then when the company emerges from bankruptcy, sell for a huge profit.  Simple, right?  What can go wrong?

The question should be what can't go wrong?  Or perhaps what can go right?  There's a reason why losing money on bankruptcy stocks ranked #8 on the SEC's complaint list last year.  And the SEC has an excellent warning about bankruptcy stocks on its web site.  According to the SEC's Corporate Bankruptcy article, "In most instances, the company's plan of re-organization will cancel the existing equity shares."  The bold is on the SEC's page.

Unwary investors (who, by definition, are gamblers) are easily lured into "investing" in shares of a bankrupt company that looks like it will turn around because there appears to be a huge jump in stock price when companies emerge from bankruptcy.  Consider UAL Corp, owner of United Airlines.  They went into Chapter 11 a little over three years ago.  After almost 38 months during which their stock traded at under $1.00 per share, the company emerged from bankruptcy with their stock trading at $40.00.  Instant goldmine!

Except the $40.00 stock was a new issue.  The old $1.00 stock was ... canceled.  That's right, if you held shares in UAL Corp before February 2, that stock is now worthless.  Let me rephrase that.  If you had gambled on UAL Corp stock before February 2 of this year, you would have lost 100% of whatever you put in.

Companies don't always just cancel the existing shares.  Sometimes the reorganization plan is quite generous and rewards those shareholders who stayed with the company by offering a certain number of new shares for each of the old shares.  A number like 100 old shares for each new share is not uncommon.  That's not so attractive if you paid 50 cents for each old share--$50 for 100--and the new shares are issued at $20.

Have you got the picture yet?  It's possible that somebody makes money trading shares of bankrupt companies, but it almost certainly won't be you.  There might be faster ways to lose money than by gambling on such stocks, but I can't think of one right offhand.  You might even be better off playing your State Lottery.