Why investors gamble on shares of bankrupt companies — Bed Bath & Beyond, for example

By James Rogers

'The history of stocks emerging from bankruptcy is not very good,' says one bankruptcy lawyer

(An earlier version of this article had the wrong university for Victor Ricciardi. It has been corrected.)

The recent movement in Bed Bath & Beyond Inc.'s stock has shone a spotlight on the attraction that bankrupt companies hold for some investors.

Bed Bath & Beyond's shares (BBBYQ) have risen 38% in the last month, outpacing the S&P 500's gain of 1.2%, despite the bankrupt home-goods retailer's well-documented woes.

Howard Ehrenberg, a bankruptcy and reorganization practice partner at law firm Greenspoon Marder, said that, while he can't discuss Bed Bath & Beyond specifically, bankrupt companies' stocks are fraught with problems for investors.

"Overall, anyone who buys and holds the stock of a bankrupt entity is almost assuredly going to lose their money," he said, noting that a company will either go into liquidation or reorganize, with the stock often being dramatically diluted.

"The history of stocks emerging from bankruptcy is not very good," Ehrenberg added.

Related: Bed Bath & Beyond: From home-goods behemoth to bankruptcy

Shares of Hertz Global Holdings Inc. (HTZ), which filed for bankruptcy protection in 2020 and exited bankruptcy the following year, trade around $19, well below an all-time closing high of $109.48 on Aug. 19, 2014.

Bed Bath & Beyond filed for Chapter 11 bankruptcy protection in April and was subsequently delisted from the Nasdaq exchange. Trading over the counter since May 4, with liquidation sales under way at hundreds of stores, the stock nonetheless continues to attract attention. Since the bankruptcy filing, investors have spent almost $200 million trading "theoretically worthless" shares, the Financial Times reported.

There has, meanwhile, been plenty of chatter about Bed Bath & Beyond on social media.

Some users on Twitter and Reddit have cited the retailer in conjunction with "Teddy," an apparent reference to Teddy Holdings LLC, which last year filed a series of trademark applications with the U.S. Patent and Trademark Office. While Teddy Holdings is apparently linked to activist investor Ryan Cohen, at this stage, there is no indication that the holding company will play a part in Bed Bath & Beyond's bankruptcy process.

Ehrenberg said he sees parallels between the purchase of shares in bankrupt companies and the meme-stock phenomenon of recent years. "They are clearly retail investors, largely on the Robinhood (HOOD) platform, that are readers of Reddit," he said. "They are people buying on rumor and hoping that by participating in a mass purchase binge, they will make money."

Related:Bed Bath & Beyond investors have spent $200 million trading 'worthless' shares -- will this holding company help them?

"To me, it's more like gambling than it is about true financial analysis of the company's stock that you want to buy," Ehrenberg added.

This type of investor behavior has also caught the attention of academics.

In a recent paper, James Clunie, a director at investment consultancy Long-Short Consulting and an honorary professor at the University of Edinburgh, and Patrick Schotanus, a visiting professor of cognitive economics at Edinburgh Business School, describe how narratives can influence trading. "It is well understood that narratives can stimulate trading, which influences prices and can change business reality, and back again in a recursive pattern," they wrote.

"Narratives in markets are not merely confined to investors seeking conviction," the academics note, pointing to the role that social media can play, as has also been noted by other researchers.

The paper has been submitted and is under review by the journal Collective Intelligence, Schotanus said.

Related:Bankrupt Bed Bath & Beyond's stock rises premarket, continuing rally

Victor Ricciardi, visiting finance faculty at Tennessee Tech University and co-author of the new book "Advanced Introduction to Behavioral Finance," also described some of the behaviors that can prompt investors to purchase bankrupt stocks.

"Representativeness bias refers to when past performance influences how an individual perceives an investment," Ricciardi told MarketWatch via email. "In particular, a person makes a general assumption about a small sample of information or experience."

So, for example, if a person made a substantial gain from a previous bankrupt stock they might conclude that all bankrupt stocks result in investment gains, according to Ricciardi. The author also echoed Ehrenberg's comments about gambling.

"The notion of the longshot bias is based on the tendency for people to overweight the probability of a long shot bet paying off, especially in horseracing and lotteries," Ricciardi added. "This is driven by overconfident behavior and dreams of becoming a millionaire overnight."

Ricciardi also pointed to a lack of investment knowledge among some investors. "In particular, the pink sheet market in which, these bankrupt stocks trade is the 'Wild West of Stock Markets'," he wrote. "Novice investors do not understand this market is unregulated and extremely risky."

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Clunie told MarketWatch that recent action in Bed Bath & Beyond's stock could also be related to predatory trading against short sellers. "By boosting the short-term share price, a group of traders can impose unrealized losses on short sellers, who may be unable to hold on to those positions" because of a "lack of resources to meet variation margin, or internal risk-management constraints such as stop losses," he said. "The short seller must then cover his [or] her position by buying at the new, higher price."

Clunie, the author of a 2010 book titled "Predatory Trading and Crowded Exits: New Thinking on Market Volatility," added that short sellers then lose, and traders who bought earlier and sell to the covering short seller gain.

"It's risky, but can be profitable to canny traders," he said.

-James Rogers

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