Rights issues: some points to bear in mind

Business Times - 31 Jan 2011

Hock Lock Siew
Rights issues: some points to bear in mind

By R SIVANITHY

AS STOCK markets are forecast to perform well this year, investors can expect more companies to raise capital via rights issues, presumably for profitable ventures that would maximise shareholder value.

To entice shareholders to subscribe to rights offers, it is customary for these to be priced at discounts, some of which are very generous. Despite this, a rights announcement usually causes stock prices to fall. Oddly, in some cases, the fall is then quickly followed by a bounce. It would be difficult to discern any predictable pattern to the post-rights announcement behaviour of stocks but there are a few points of interest investors should take note of.

The most commonly cited reason for a price fall after news of a capital- raising exercise is that the latter leads to a dilution of earnings per share (EPS), which in turn leads to a fall in the company's return on equity (ROE). So poorer EPS and ROE are said to lie behind the selling.

In reality though, these are simply accounting illusions; if markets are efficient and operate as proper discounting mechanisms, there should really be no effect on the share price of a rights announcement.

This is because in an efficient market, a company's share price should reflect the present value of all the company's expected future after-tax cash flows, of course discounted at an appropriate risk-adjusted rate. This means that the price should not fall if the market expects management to earn a suitable rate of return with the new funds.

In fact, if the market believes that the money raised is to be channelled to a very attractive avenue, then the announcement of a capital-raising exercise together with details of where the money is going may even lead to a share price rise.

The keys, of course, are the market's perception of management's ability and proper disclosure. In the case of some companies that have tapped the equity market for funds over the years but have not performed after receiving the money, it's a sure bet that another rights announcement will lead to a plunge in their shares.

Stated differently, a price drop after a rights announcement could be taken as an indictment of management's capability to employ the capital properly.

Moreover, companies which are vague about what the money is for - 'working capital' or 'acquisitions as and when they present themselves' are sometimes cited, which from the viewpoint of a sophisticated market is actually useless information - may well find themselves penalised, whereas those that are able to provide specifics should not.

This is because vagueness may be construed as conveying negative insider information about the company's prospects and so would be detrimental to the share price. The corollary is that companies that are transparent should at the very least not have to suffer too badly compared to companies which are cagey and elusive - an observation that fits well with the belief that good governance should over time translate to better share prices.

A second, related reason usually given for a price drop after a rights announcement is that it increases the supply of shares in the market. This sup- ply/demand reasoning assumes that the demand curve for shares is downward sloping where more can be sold at lower prices, and partly explains why companies always offer rights shares at a discount.

However, demand for equities is unlike demand for normal goods, where quantity demanded rises with lower prices. In fact, it is often the case that demand increases at higher prices as the herd instinct or greed kicks into full gear - recall, for example, that shares of worthless Internet companies were more actively traded and in greater demand at ever-higher prices during the dotcom bubble 10 years ago.

Discount

Moreover, academic studies of the sale of large parcels of equity strongly suggest that the effect on share prices is unrelated to the size of the parcels but is more correlated to the informational content of the sale. For example, the largest price falls came when the sales were made by the company's directors since this probably conveyed negative inside information about future prospects.

In effect, this suggests that it may even be possible for companies which the market likes - ones that have good track records when it comes to using capital profitably and are transparent - to raise capital through large parcels without having to offer much of a discount to the prevailing market price.

The fact that some do is probably a token gesture of goodwill to existing shareholders; conversely, the existence of a large discount may well have negative consequences for the stock price because of the implied information. Shareholders should bear all of this in mind when next they are asked to cough up cash to subscribe to a rights offer.

Interesting read! The part on "However, demand for equities is unlike demand for normal goods, where quantity demanded rises with lower prices. In fact, it is often the case that demand increases at higher prices as the herd instinct or greed kicks into full gear - recall, for example, that shares of worthless Internet companies were more actively traded and in greater demand at ever-higher prices during the dotcom bubble 10 years ago." reminded me of something I read about recently by Warren Buffett in one of his shareholders' letters if I'm not wrong. It goes something like this:

If you are going to be a meat eater for the rest of your life and you are not a seller of chickens or cows, would you like rising or falling prices of meat? If you are going to buy a car and you are not a car manufacturer, would you like rising or falling prices of car? For both, the answer is obviously falling prices. Then, how come when it comes to investing, people are drenched in fear when prices fall and are in euphoria when prices rise?

because not all stocks are meat?

Herd Instinct. Safety in Number. "if i fail, thousands will be with me, so is ok" mentality. Alternatively, can be related to "kiasu" as well. And is a common mentality.
How many dare try not to conform to norm in your day to day lifes ? And this built-in to the way we think instinctively.

If the price don't rise, how are we going to divest at a decent profit ?

(06-02-2011, 10:05 PM)Nick Wrote: If the price don't rise, how are we going to divest at a decent profit ?

We must not be excited by rising prices and vice versa. WB is referring to the emotions and not the action per se. Yes, we have to sell for profits when the time comes but most investors out there are are buying/selling based on emotions and not on facts.