Driving to an IPO

Ex-bankrupt IPOs: General Motors’ coming initial public offering may be a hard sell. After all, the automaker burnt investors with its Chapter 11 filing a little over a year ago. But, companies that emerge from bankruptcy can significantly outperform the stock market. On the other hand, a third of them go bust again. The IPO of GM and, in time, those of other cleaned up ex-bankrupts like Delphi and Chrysler, deserve cautious investor interest.

Shares of formerly-bankrupt companies tend to do well if markets are anywhere from plodding to bullish. A portfolio of such stocks including Federated Stores (which later became Macy's) in the early 1990s, and another after the dot.com bust in the early 2000s, would have sharply outperformed stock indices. The early 1990s batch returned about 28 percent more over 200 days than stocks of similar pubic firms, according to a study by New York University professor Edward Altman.

There are several possible explanations. Analysts caught out by companies going bust may be overly cautious about their prospects when they return to the public eye. Executives may also be tempted to lowball expectations. After all, they get to take credit — and some of the profit — for beating targets.

But investors in companies that have been through Chapter 11 still need to be selective. About a third of re-emerging companies go bust again — entering what is known as Chapter 22 — within four years, according to academic studies.

For some firms, this happens because their products become obsolete. Silicon Graphics, for example, produced ultra-high end computers. The switch to networked groups of cheap machines doomed the group to a second bankruptcy. But the biggest cause of recidivism is too much debt, according to Altman. Those who file again for Chapter 11 protection on average have almost four times as much debt as equity. Those that avoid this fate on average have a debt-to-equity ratio of less than 1.5.

Uncle Sam’s involvement in GM’s bankruptcy may therefore turn out to be an important factor. The government forced pain on all parties, leaving the company’s balance sheet relatively healthy. The firm has about $23 billion of debt and other obligations, mainly healthcare. And there’s a $27 billion hole in its pension fund. Yet it has more than $23 billion in cash and may raise additional money through the IPO.

So a quick trip back into bankruptcy looks unlikely. Still, investors will have to take a careful look at GM’s IPO valuation. The company might push for a heady price in an attempt to minimize US taxpayers’ paper losses on the bailout. With GM still having plenty to prove, that could leave little upside.