Aside from filing for bankruptcy recently, what do Hertz Global Holdings Inc. (NYSE:HTZ), Whiting Petroleum Corp. (NYSE:WLL) and Ares Management Corp. (NYSE:ARES)’s Neiman Marcus have in common?
The answer may take many investors by surprise. After announcing that they would be filing for Chapter 11 bankruptcy, the companies listed above – as well as several others – have seen a spike in their stock prices.
Ares Management, the owner of Neiman Marcus, didn’t even see its share prices flinch after its component business’ May bankruptcy filing. This isn’t too surprising considering that Neiman Marcus is only one of the company’s many revenue streams, and it is unclear how much of the group’s revenue this one portion made up after the $6 billion acquisition. Shares are up almost 100% from March lows as of June 9.
What is more unusual is that Hertz and Whiting saw their share prices jump 268% and 309%, respectively, in the wake of their bankruptcy announcements.
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Despite investor optimism, nothing has changed about the way Chapter 11 bankruptcy works that could conceivably increase shareholders’ prospects.
Unable to make payments on crushing amounts of debt, a company files for legal protection under Chapter 11, which allows it to continue operating as normal while it comes up with a plan to restructure in a way that settles as much of its debt as possible before re-entering the stock market.
The typical outcome of this is that existing shares are cancelled, the company’s creditors receive partial settlements of cash and newly issued stock while shareholders receive nothing. Out of 41 publicly traded companies that went bankrupt in 2009 and 2010, shareholders of four of them got any sort of return while the rest were completely wiped out.
As shareholders are the last in line in terms of repayment priorities when a company restructures, why would there suddenly be a jump in the number of investors wanting to buy shares of companies entering Chapter 11? The answer could lie in high optimism creating an increasingly speculative environment. However, there’s one other important new variable to consider here: the unprecedented speed with which consumer spending and stock prices plummeted in March.
Optimism running high
The glass is definitely half full in U.S. equity markets, with the S&P 500 up year to date and the Nasdaq surpassing 10,000 for the first time in history on June 9. The gap between share prices and the declining earnings of most publicly listed companies has rarely been higher, at least in the U.S.
Following lockdowns to prevent the spread of the Covid-19 virus, economies around the world are beginning to reopen, sparking optimism that the worst is already over for company earnings. If you buy now, how much will you see the value of your stocks rise when second-quarter and third-quarter earnings reports come rolling in, causing demand to increase further?
The result is that the Buffett Indicator, which measures stock market valuation by comparing the gross domestic product of a country to the total market cap of its businesses, was at a ratio of 152% for the U.S. on June 9, indicating that the stock market is “significantly overvalued.” In fact, it has never before been this overvalued.
Market euphoria of this level unsurprisingly leads to increasingly risky and speculative buys as investors look for ever-more-elusive cheap stocks, often with the assumption that a “greater fool” will come along at some point and pay more for their shares of businesses with dim prospects.
“Something we really never think we’d see but we saw yesterday — Buying hundreds of billions of shares of bankrupt companies, sending their shares 100%, 200% and 300%,” commented Julian Emanuel, chief equity and derivatives strategist at BTIG, on CNBC’s “Squawk Box” on Tuesday. “It’s sort of this speculative behavior that we saw at the end of 1999 and the beginning of 2020. It really doesn’t make rational sense.”
Betting on a whiplash recovery
In addition to optimism and speculation running high, there is another factor that may be contributing to the increase in bankruptcy investments: the speed with which the economy shut down and is reopening.
This was preceded by stock prices taking a one-month nosedive of 34% before rising nearly to their pre-crash levels over the next two months. Things have never happened this quickly and dramatically before in the stock markets. Driven by a combination of easy access to vast amounts of data and liquidity and the increasing popularity of index and algorithmic trading, the potential for volatility in the markets has skyrocketed.
Combined with the expectation that businesses will quickly return to “normal” now that lockdowns are coming to an end, investors could be betting that a whiplash recovery will result in companies that are entering Chapter 11 being able to come up with bankruptcy plans that are far more generous to shareholders. If recovering cash flows enable a company to pay off its creditors in full, shareholders may not come out of the deal empty-handed after all, potentially being allowed to keep their shares or receiving new shares that would quickly be bid up in price.
Joining the bankruptcy party
It’s not just bankrupt companies that are witnessing this risky new investing strategy. Companies that warned investors of potential bankruptcies have also seen their share prices pop on hopes that recovering economic conditions will bring them a last-minute save.
For example, Norwegian Cruise Line Holdings (NYSE:NCLH), AMC Entertainment Holdings Inc. (NYSE:AMC) and Chesapeake Energy Corp. (NYSE:CHK) warned investors in the past couple of months that they are likely to file for Chapter 11 bankruptcy within the year. They have seen their share prices increase by 141%, 18% and 96% to date, respectively, since the warning announcements. Chesapeake was up 370% before it announced on June 8 that it is indeed preparing to file for bankruptcy in the coming week, after which prices plummeted (though they are still up overall compared to March levels).
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Conclusion
While some investors are putting their money in the stocks of bankrupt or near-bankrupt companies in the hopes that market euphoria and the recovery of the economy will net them some sort of return, this is still an extremely risky and speculative class of investments.
CNBC’s Jim Cramer noted on Tuesday, “A lot of people that are coming in and want to make quick money seem to think that if they buy Chesapeake, there’s going to be someone willing to pay higher. I question whether it’s really a long-term strategy and not just a dice roll, a back-alley dice roll.”
I am inclined to agree with Cramer’s assessment here. Even in the case of a company that seems likely to give its shareholders something as part of its Chapter 11 plan, buying shares when they trade for dollars instead of pennies is overpaying. Shareholders still have last priority in a restructuring agreement and very rarely get anything.
Nevertheless, it will be interesting to see (from the sidelines) whether this recession will follow in the footsteps of its predecessors, or whether loose monetary policy and modern speeds of change will result in bankruptcies being slightly more profitable for bondholders and shareholders. If this does indeed become the case, we could see some interesting changes in how investors of all types approach corporate insolvency.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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This article first appeared on GuruFocus.