(Robin Hartill, CFP®)
Revlon (NYSE: REV) is the latest company to file for Chapter 11 bankruptcy protection, only to see its stock price soar. Although stocks have fallen this week, they are still up nearly 400% since June 13. The same phenomenon happened in 2020 when retail investors rushed to invest in big names like Hertz (NASDAQ: HTZ) and JCPenney after filing for bankruptcy.
At least part of Revlon’s surge was driven by meme stock enthusiasts in forums like Reddit’s WallStreetBets. Investors may also be attracted by the possibility of buying shares of an iconic brand like Revlon at very low prices. But the reality of buying stock in a bankrupt company isn’t pretty.
People also read…
What causes a cluster of bankruptcies?
Companies file for bankruptcy when their debt becomes unmanageable. Revlon has $3.3 billion in debt, according to its latest quarterly earnings report. But there are several reasons why a bankruptcies rally may occur.
- Investor Optimism: Some investors believe that a heavily indebted company can emerge from bankruptcy in a stronger financial position. In the case of Revlon, rumors that Indian conglomerate Reliance Industries was considering a takeover helped fuel the cosmetics giant’s share price rise.
- short term trade: Sometimes, after the price of a stock has fallen to unexpected levels, its price temporarily goes up. This phenomenon is known as the dead cat bounce in investing. Day traders and other speculators jump on what looks like a bargain, driving up the price of the stock. It’s not about trading fundamentals, mind you. It’s just trying to make a quick buck by timing the market.
- It’s a short press target: Retail investors can buy shares of a struggling company that has been heavily shorted in hopes of triggering a short squeeze. As the stock price rises, those who are short must buy stocks to close out their positions and avoid further losses. Think GameStop in 2021. With over 50% of Revlon’s float sold short, this phenomenon is likely driving the price higher.
Why bankruptcy will likely be ugly for Revlon investors
Things are unlikely to end well when you invest in a bankrupt company. Here’s what shareholders can expect.
Once a company has filed for bankruptcy, it usually no longer meets the requirements of major stock exchanges, so it is delisted. (As of this writing, Revlon still trades on the New York Stock Exchange, but the NYSE has begun the process of delisting the stock.)
But there is no law prohibiting trading shares in a bankrupt company. Instead, failed companies will often trade on over-the-counter markets, which have incredibly lax financial disclosure requirements. The stock will trade with a five-letter ticker ending in “Q”. Some traders will be able to take advantage of the action’s wild price movements, although many will lose money if they don’t time things correctly.
Where things really go wrong is in bankruptcy court. In a Chapter 11 reorganization, common stockholders take their place in line with all of the company’s other creditors. There is a strict pecking order for who gets paid first in bankruptcy court. Although it’s a bit oversimplified, it usually looks like this:
- Secured creditors, whose receivables are guaranteed by securities; for example, a bank that holds a mortgage.
- Preferred stock ownersa type of security with both stock and bond characteristics.
- Common stock owners
As you can see, ordinary shareholders come last. Ordinary shareholders only receive crumbs if each level of creditor above them has been paid in full. Typically, this means common stock owners have nothing left.
Although a Chapter 11 company may continue to operate, the court sometimes approves what is called a Section 363 sale. But that’s not good news for common stockholders. There is rarely any money left over to compensate those who own common stock after the sale.
Even when a reorganization does not result in a sale, ordinary shareholders generally do not recoup their investments. The most common scenario is that the reorganization cancels the existing shares and only the newly issued shares of the reorganized company will have value. Usually this leaves ordinary shareholders with little or nothing.
The Financial Industry Regulatory Authority (FINRA) warns: “The cases in which the old shares can be exchanged for shares of the newly reorganized companies are particularly rare.”
A notable exception to the rule is Hertz. The company emerged from bankruptcy in 2021 after a bidding war that injected $5.9 billion in capital into the car rental giant. After its initial bankruptcy filing, the stock fell as low as $0.40 – but common shareholders walked out of the deal with around $8 a share. It appears that some investors are buying Revlon shares, hoping they will follow a similar trajectory.
But Hertz’s situation was unusual. The company filed for bankruptcy at a time when travel was at a standstill due to COVID-19. The deal that bailed Hertz out of bankruptcy came 13 months later amid a dramatic increase in car rentals and domestic travel.
In short, Hertz’s dramatic crash and rebound occurred under very unusual circumstances. Investors should not buy shares in failed companies expecting to strike a similar deal.
Don’t count on Revlon sitting pretty
Although you always hear stories of people making big money on very risky short-term trades, long-term investing is the most proven way to build wealth. So avoid investing in Revlon and other struggling companies just because they look like easy money. If you choose to invest, make sure you are comfortable with the high probability of losing big.
10 stocks we like better than Revlon
When our award-winning team of analysts have stock advice, it can pay to listen. After all, the newsletter they’ve been putting out for over a decade, Motley Fool Equity Advisortripled the market.*
They just revealed what they think are the ten best stocks investors can buy right now…and Revlon wasn’t one of them! That’s right – they think these 10 stocks are even better buys.
* Portfolio Advisor Returns as of June 2, 2022
Robin Hartill, CFP® has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.