Post-Reorg Equities

How attractive are stocks that emerge from bankruptcy?
 

By Morgan Hartranft

Since the beginning of the COVID-19 pandemic, iconic firms such as Brooks Brothers, Hertz, Neiman Marcus, and J. Crew have fallen into bankruptcy. As the crisis continues to unfold and widespread closures continue, it is likely more companies will follow suit.
 
Many investors may shy away from companies following a reorganization and reemergence because the memory of bankruptcy is a lingering one—despite an altered capital structure. This presents an exciting opportunity for less judgmental investors willing to evaluate the restructured company for what it is now and exploit the momentary disgust of others.
 
Some famous investors gravitate toward just these types of situations. Seth Klarman highlights post-reorganization equities as an attractive opportunity in his 1991 book Margin of Safety. According to our research, subsequent academic studies affirmed the wisdom of Klarman’s approach. A 1998 study found that firms emerging from Chapter 11 filings exhibited large positive returns in the 200 days following their relisting on the public market. JP Morgan conducted a similar study in 2004, finding that, between 1988 and 2003, 117 post-reorg equities had a relative performance of 85% to the S&P 500.
 
But our research has found no major studies of the performance of post-reorg equities since 2010. In part, this is due to data issues: it’s difficult to find lists of post-reorg equities. But thanks to a comprehensive new data set from BankruptcyData, a leading provider of data and intelligence on corporate bankruptcies, we were able to look at the recent performance of the 93 companies that filed for bankruptcy between 2008 and 2019 and went through a reorganization to relist as a publicly traded equity. In Figure 1 below, we show the distribution of these bankruptcies by year.
 
Figure 1: Count of Public Equity Relistings Following Bankruptcy

Source: BankruptcyData
 
We constrained our analysis to the 49 companies that emerged with a market cap greater than $100M to avoid results being skewed by a few uninvestable stocks. Our analysis found that post-reorg equities from 2008 to 2019 consisted of more losers than winners, but successful firms produced notably high returns. One year following emergence, the average return was 19.8%, with the Russell 2000 returning 11.2% during the same period.
 
Figure 2: 1- and 2-Year Returns to Post-Reorg Equities vs. Russell 2000

Source: BankruptcyData, Verdad analysis
 
Our research reveals that company returns one year out were widespread, with the 25th percentile being -62%, the median being -15%, and the 75th percentile being 46%. The returns became more extreme two years out, with the 25th percentile being -76%, the median being -35%, and the 75th percentile being 65%. The returns of post-reorg companies were more volatile than the Russell 2000 during the same time period, with more extreme upside and downside.
 
Figure 3: Distribution of Returns to Post-Reorg Equities and Russell 2000 by Quartile

Source: BankruptcyData, Verdad analysis
 
According to our research, about 22% of post-reorganization equities suffered bankruptcy-level losses (> 80% loss) within two years of reemergence.
 
With such wide distribution of returns, we looked for a simple way to sort the winners from the losers and found that sorting companies based on valuation was an effective predictor of outcomes through our analysis. Companies with an EBIT yield of less than 0% had an average two-year return of -21%, companies with an EBIT yield between 0% and 20% had an average return of -5%, and companies with an EBIT yield of more than 20% had an average return of 61%.
 
 Figure 4: EBIT Yield and Average 2-Year Return

Source: BankruptcyData, Verdad analysis
 
These results suggest that a simple metric such as EBIT yield at emergence could be able to distinguish between future winners and losers—an encouraging sign for investors interested in reorganized companies. If investors are able to distinguish between which relisted firms will remain solvent and which will later end up refiling for bankruptcy, investing in companies post-bankruptcy may potentially become less risky.
 
The inconsistent performance of post-bankruptcy stocks points to the wide range of possible outcomes for equity holders. While it is true that companies successful after emergence generally produce excess returns due to initial undervaluation, the post-reorg losers offer large downside risk and losses. We hope this information can help guide future investment decisions regarding the current cohort of companies pushed to bankruptcy by COVID-19.
 
Acknowledgment: Morgan Hartranft is a rising junior at Hamilton College. She will be interning next summer at Deutsche Bank and is interested in pursuing a career in business or finance.