Investing in bankrupt companies – madness or method?

A slice of the investing world seems to have fallen in love with the idea of investing in bankrupt companies. A ‘portfolio’ (entirely theoretical) of ‘garbage’ companies, so-called because they have a credit default swap of more than 1000 points, has seen incredible returns since early April, according to data from Man Group.

This development seems entirely in keeping with a stock market that appears to be happy to disregard the dire economic situation around the globe. Why would investors be keen to buy shares in firms that are on the brink of bankruptcy, or in the case of firms like HTZ-US, already in that condition? Does this not prove that the massive QE programmes of the past decade have nullified the idea of risk, and that the stock market is now just a perpetual motion machine that only goes up?

Well, no. In fact, while this garbage portfolio seems to have become the new fad, it remains a tiny part of the market. Most investors continue to put their money into high-performing companies. Instead of a ‘dash for trash’, what we have actually seen has been a ‘flight to quality’; faced with an uncertain outlook, investors have raced to buy stock in well-capitalised companies with good credit ratings and strong cash generation. That these often happen to be concentrated in big tech stocks that have already done well is but another reflection of the idea that the best stocks will do well. In bull market, investors and traders should seek out those stocks with the best fundamentals and the most attractive trends. Usually, those two things will go together.

There will always be those who seek out something different, however. It might seem madness to actively invest in companies that may be about to fall into bankruptcy, but the low stock prices and the potential for some good news (e.g. the company being bought out) that can send the stock soaring is sometimes too great a temptation to resist. Some investors like to find stocks that have limited downside in that their shares trade in single figures. ‘After all, it can only go to zero’ is something often heard in trading.

It is the same dynamic that makes penny stocks so exciting. Big names like Vodafone or BP in the UK, or JPMorgan and Chevron in the US, rarely see returns in the hundreds of percent, at least not in a short space of time. But both small caps and the aforementioned ‘garbage’ firms can (the key word here) see huge returns in a very short space of time. The recent outperformance of such a portfolio of garbage firms is an extreme manifestation of an existing phenomenon. Perhaps these aren’t long term investors. Perhaps instead the people buying this stock are merely hoping for one last rally, that takes a stock price from $1 to $4, a huge return. Having benefited from this, they may move on.

It is perhaps the modern equivalent of the great value investor Ben Graham’s ‘cigar-butt investing’ approach. Graham looked for cheap companies that he thought might be undervalued based on their book value. Even if the company ended up going out of business, the total value of their assets might mean that stockholders would get a decent return. Many of the companies in the ‘garbage’ portfolio mentioned above have high debt levels, and so stockholders will probably get nothing if and when it does go bankrupt.

But these traders are not likely to stick around for that. Instead, they will look for the new opportunity. It is important to remember that with big rewards come big risks. Indeed, out of ten companies in such a portfolio, eight may eventually go to zero. But the two that don’t could see returns that make up for all the other duds. Investors following this strategy need to be aware of the risks, and make sure to spread their risk around, avoiding putting all their eggs in one potentially-decrepit basket.

It is not for everyone, and is unlikely to yield such impressive returns in the future, but far from signalling a dysfunctional market environment, this enthusiasm for risky companies is just another part of investing.