Beware the Bargains

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Bottom fishing for bargains in the stocks of distressed companies is a surprisingly popular sport, but careless investors are likely to reel in something rotten.

An active fraud investigation hasn't kept buyers from snapping up millions of shares of embattled HealthSouth. In Chicago an investment club took a flyer on bankrupt UAL, the parent company of United Airlines, believing that the stock was set to soar. More than 57 million shares of bankrupt WorldCom were traded last Thursday on news that WorldCom had reached a revised settlement with the Securities and Exchange Commission that will give some shareholders stock in the new company when it comes out of bankruptcy. True, but this applies only to people who owned WorldCom before June 25, 2002. When WorldCom emerges from bankruptcy, in fact, its current stock will be canceled and shares that were worth about 6 each on July 3 won't be worth a penny.

The bankruptcy process can be complicated, but if you're a stockholder what you need to know is pretty simple: holders of common shares go to the bottom of the list when assets of a corporation are divvied up. To be sure, a company can emerge from bankruptcy stronger — and profitable. But the "new" company will issue a "new" stock, so any stock you purchased before it comes out of bankruptcy usually has no value. How can you tell if the stock is old or new? If its ticker symbol ends in Q, that's the signal to "get out quick." A "Q" means the company is in bankruptcy, and even the pros say figuring out details of who gets what, and when, is difficult. "The information flow can be very sketchy. Management is in turmoil. It's a very imperfect market," says Jonathan Rosenthal, a partner at Saybrook Capital, a Santa Monica, Calif., investment bank that focuses on restructuring bankrupt companies.

If you want to invest in the distressed, doing it through mutual funds will limit your risk. Among those seeking profit in turnarounds are junk-bond funds and such value funds as Longleaf Partners, Third Avenue Value Fund and Excelsior Value and Restructuring Fund. Or you can wait for the reorganized company to issue new common shares. Because by then the old ones will be dead fish.

Sharon Epperson is a correspondent for CNBC