ABSTRACT

The low priced stocks of bankrupt companies have attracted numerous (apparently) unsophisticated investors. The naive reasoning has been, if the stock that at one time was selling for $20, $30 or $50 a share is now selling for a few cents, how much lower can it sink? Perhaps lightening will strike and the stock will eventually get back to its earlier levels. Even if this stock does not recover, perhaps the next one will. The cold hard results of this study reveal the dangers of such irrational reasoning.

In the sample of 154 firms that this study is based on, the total investments of the common stockholders of 93 firms were totally wiped out. Overall, these shareholders suffered an average loss of around 70 percent. While a very few bankrupt stocks may produce stratospheric gains, the risk of loss inherent in most such situations is likely to be far greater than those potential gains. One is exposed to the uncertainty of the final resolution of the bankruptcy process, total time for completion of the process (averaging two years), the quality of the reorganization plan and successful implementation of the plan. A high percentage of reorganized firms fail a second time.

Based on the results of this study and the general nature of uncertainty surrounding the complex bankruptcy process, we recommend that unsophisticated individual investors not invest in the stocks of bankrupt firms. To make abnormal returns in this area, an investor would require superior financial analysis skills and a thorough understanding of the intricacies and legal wranglings of the bankruptcy process (and perhaps a bit of luck).

INTRODUCTION

Casual empiricism suggests that stock market may overreact to bankruptcy announcements causing the prices of stocks to plummet during the bankruptcy period. For example, about seventy percent of the firms in our sample had stock prices under $2 at the time of filing. Such low priced stocks of bankrupt companies have attracted numerous (apparently) unsophisticated investors. The naive reasoning has been, if the stock that had once traded for perhaps $30 per share is now selling for a few cents, how much lower can it sink? The truth is "  »»» Click Here For More