Troubled Stocks, Big Profits?

Shares in airline, casino, auto, and other distressed sectors have surged recently as investors make recovery bets. But this is a dangerous game to play

By Ben Steverman

Betting on distressed companies—whether they are nearly bankrupt or just enduring a long financial decline—can be lucrative.

It's the riskiest wager an investor can make. In bankruptcies, equity shareholders can lose everything. Companies that don't file Chapter 11 can see their shares bump along at low prices for a long period of time. But recently investors who dared to snap up shares of troubled firms at single-digit prices have seen some handsome returns.

Shares of outfits in the troubled casino, airline, and auto sectors, banks, and other cash-strapped companies have surged in recent weeks on hopes that an economic recovery this year could save the stock market from a wave of bankruptcies.

The danger is real. According to BankruptcyData.com, 64 public companies have filed for bankruptcy in the first three months of 2009, including Lyondell Chemical, Nortel Networks, and casino firm Trump Entertainment Resorts. The total assets of these 2009 bankruptcies was $100.1 billion. By contrast, in the first quarter of 2007, the market had seen just 16 public company bankruptcies valued at $1.1 billion.

Airline Sell-Off Overdone?

A share price below 5 is a commonly recognized sign of bankruptcy danger to equity investors. In many hard-hit industries, it's now a common sight.

With a stock so close to zero, it's fair to say stocks are moving based on their chances of survival, not other fundamental measures of value. "You see stocks trading not on expected earnings, but on whether they're going to live or die," says independent market strategist Doug Peta.

As a result, the rewards for escaping bankruptcy can be substantial.

Among the recent buyers of these risky stocks has been Robert Bacarella, portfolio manager of the Monetta Mutual Funds (MONTX). He is investing a small portion of his portfolio in casinos, airlines, and banks despite the risk embedded in their single-digit stock prices.

In many cases, "[Wall] Street is telling you this company is going bankrupt," he says. But Bacarella expects an economic recovery this year, which could save many of those troubled firms. The sell-off in airline stocks, for example, was "way overdone," he says.

Some apparently agree. Airlines like Delta (DAL), United parent UAL Corp. (UAUA), American parent AMR Corp. (AMR), and U.S. Airways (LCC) are up 12% to 22% since the start of April, though all four still trade below 7 per share. Delta, UAL, and U.S. Airways have each endured bankruptcy proceedings in the past decade.

MGM's Roller-Coaster

The recent rally has been even stronger in industries harder hit by the recession.

In just two trading sessions, the battered shares of casino operator MGM Mirage (MGM) surged 76% as investors hoped that bankruptcy could be avoided through some asset sales.

MGM Mirage traded above 100 per share 18 months ago, but these days Morningstar (MORN) analyst Jeremy Glaser gives the casino operators' shares a fair value estimate of zero. "We think [bankruptcy] is the most likely outcome," he says, citing MGM's heavy debt load and overly ambitious expansion plans.

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