Special Situations, Part 3 — Bankruptcy

• Posted by DynamicHedge
• on October 4th, 2010

Continued from the previous post Special Situation Overview, Part 2 this is part three of my review of Joel Greenblatt’s book, “You Can Be A Stock Market Genius.”

Bankruptcies

The chapter on bankruptcies and restructuring covers many of the same principles that the other chapters covered.  Unique investment opportunities are created when you have a combination of emotional sellers clouded by either greed, fear or ignorance.

The subtitle of Mr. Greenblatt’s book is, “Uncover the secret hiding place of stock market profits.”  I’ve always considered bankruptcy investing as a true professional area because you is really have to work to uncover and separate value from garbage.  You need to do your homework and be very choosy about which bankruptcies to invest in.

Avoid buying the common stock of a company that is undergoing bankruptcy.  Instead, wait for the newly issued stock of companies emerging from bankruptcy.  If you are an analytical type you can dissect the bonds, bank debt, and trade claims that can often trade at deep discounts to par (20-30 cents on the dollar).  If you choose to go this route, be warned, there are already very smart well capitalized funds dedicated to this practice competing with you.  The tangled web of legal and financial issues in most cases will scare off just about everyone except the vultures.

For most, focusing on the newly issued equity of unloved mid-sized stock (I.e. not GM) that is going to survive after a reorganization will produce good tradable opportunities.  The theory is that the former creditors are often settled with new stock instead of cash in the bankruptcy proceedings and are rarely interested in being long-term investors after already going through one bankruptcy.  These former creditors are now willing and motivated sellers just hoping to salvage something out of their previous unfortunate investment and move on.  This motivated selling can create bargain priced equity in a company that has some (but not a lot) decent underlying value.  Make sure you understand the business and the opportunity.  Read the disclosure statements issued by the company thoroughly and critically.  These bankruptcies are trades not long-term investments.  Don’t fall in love with the story, get in and get out.

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