Are rights issues good for investor returns?
Posted on May 23, 2008 by Richard Beddard
Filed Under Markets |
Historically banks have always been seen as an income portion of a portfolio… They’re Steady Eddie companies. Unfortunately the landscape we’re in now, with banks being so highly leveraged, it’s very difficult to see the value argument. If you take a look at Bradford & Bingley. This stock currently yields around 12%. Alliance & Liecester yields around 10%. Lloyds TSB yields around 9% so in historical terms and looking at PE valuations, these banks are cheap. But they’re not cheap in the current environment because a rights issue dilutes. Dilutes the shareholders’ dividend. They have to up the dividend to keep it to the same proportion. And whilst banks are out there diluting equity, there’s very little value in these for the private investor and for the institutions.
I’ve discussed bank valuations, and dividends, before and come to similar conclusions. But what does the data show? Do companies generally do well after rights issues, or do they generally do badly?
Here’s a chart from a study*1 quoted in a paper by James Montier, that suggests they do badly:
The companies that conducted rights issues between 1991 to 1995 (the lowest of the three lines) interest us most because that was a time somewhat analogous to today, when companies came to the market needing cash during the UK housing recession. Returns were negative before the rights issues and got worse after them.
The smooth middle line shows returns from companies conducting rights issues in more buoyant times (1986 - 1990), when they were more likely to be taking advantage of high valuations to raise money. Before the rights issues the companies performed well, after them the returns were equally as bad as in 1991-1995, if not worse.
The third line (the one that goes up) shows returns for companies conducting open offers between 1991 and 1995. I can’t explain why they were positive, and Mr Montier doesn’t offer an explanation. But he’s unequivocal about rights issues:
Regardless of the motive, the outcome is clear from even a cursory glance at the chart [above]. Rights issues are bad news for investors.
He thinks investors, and not just bank shareholders, are in a sucker’s rally, and points to this wonderful commentary on the Dow Jones during the Wall Street Crash to demonstrate just how easy it is to be suckered.
Footnotes:
- Capstaff, Ngatuni and Marshall (2007) Long-term performance following rights issues and open offers in the UK.
Comments
8 Responses to “Are rights issues good for investor returns?”
Leave a Reply
Hi Richard,
Another interesting chart from the archives of James Montier.
The web site link was fascinating also. It is a shame we do not have a similar archive of quotes from around August 2007 until the present day. Hopefully someone will compile them one day if this turns into another 1929 (I am betting it will not but there you go).
It would be interesting to superimpose the chart of the Dow Jones relative to the constituent PE ratios to see how this panned out. How good were PE’s as a predictor of stock market returns at this time (no doubt there have been many studies).
Regards
Robin
Hi Robin, I have a book that covers this territory - ‘Anatomy of the Bear‘ by Russell Napier. Extraordinarily I just picked it up and turned to a random page and on it is a chart showing the cyclically adjusted (i.e. long-term I pesume) PE of the S&P Composite (US stock market) since 1881.
It shows very obvious spikes in 1929 (PE>30) and 2000 (PE arond 40)(those years should be familiar as the peaks preceding infamous crashes)and lows in 1921, 1931 and 1981 (all PE around 5). The source is Robert (Irrational Exuberance) Shiller’s data page at Yale although I’m not sure whether you can find charts there or just raw data.
When I get a mo I’ll have a poke around, or take a picture of the chart in my book and post it on the blog.
Interestingly the bottom in 2002-2003 is low by 2000’s standard but high in comparison to any other period post Wall St Crash. I’ve commented on this somewhere before!
Regarding the false bottoms of the Wall Street Crash - it’s funny - but I’m sure you could make the opposite case i.e. dig out all the people who said ‘we’re screwed’ and were right. After all, Montier is hardly alone in being bearish right now - as the author of the website with the Dow chart is. Say they’re right. When they annotate the chart for 2008-2010 will they include their views to show pessimists abound too?!
Your observation is very insightful. It made me realise that this annotated chart is just journalistic sensationalism.
I had a rout around the internet and found this web page which shows the PE relationship.
http://seekingalpha.com/article/77304-s-p-500-historical-trailing-12-month-p-e-ratio
You can view high PE at other times which did not lead to significant stock price declines. It seems we need more things to fall into place e.g. house prices, global inflation, the exchange rates, long term interest rates should all be factored in.
Oil is another area where there are currently an equal number of bulls and bears. Both groups give persuasive arguments.
Personally I do not know if we have a supply shortage right now (and some of it is undoubtedly explainable by the dollar weakness and/or speculation), but I think that most people expect there to be a supply shortage in the fairly near future and perhaps the high price of oil is just a reflection of that sentiment.
The continued failure of anyone to find a sustainable, green, alternative energy source after all these years cannot help either. I think that it is a bit unrealistic to expect the oil majors to solve the energy problem. There is a clear conflict of interest.
The majors also say that there is no supply shortage so, if that is the case then they should not get upset by having a windfall tax on their unjustified profits. They say that if they get taxed then they will not be able to make future investments in green energy. I say, good, give the money to people who actually want to solve the energy problem today and not tomorrow. Let someone else have a piece of the energy pie.
Hi Robin,
That Seeking Alpha post uses the trailing 12 month PE ratio. I think most people agree it doesn’t have great predictive power for stocks or markets - nor would you expect it to since it’s the single most widely quoted financial statistic (I reckon!).
The Shiller data uses the average of ten years of earnings, which I think is a better predictor because we’re not being bamboozled by temporary surges, or depressions in earnings. Also, with the exception of a few academics (like Shiller and our own Keith Anderson) and Mavericks (James Montier) most people seem to ignore it.
The greatest champion of the cyclically adjusted PE (Ben Graham) is dead!
I suspect the problem is that most people don’t have ten year time horizons but if you base your investment decisions on ten year averages you can’t really expect to say much insightful about what will happen in the next year.
Here’s the chart, photographed from ‘Anatomy of the Bear”:
Ironically, we’ve talked about all this before…
Oil? Don’t start me on forecasting again. There lies insanity
Don’t forget too that the high PE valuations for banks at the moment are generally based on earnings from before the credit crunch! Forward PE is likely to be much lower.
Noted. Ask yourself a simple question in the case of Banks - Why do they need propping up with a Cash Call?
Well again the answer is simple; it’s because the CEO and his co-directors have shown themselves to be INCOMPETENT. So do they become competent with your cash? NO! they carry on just like a punter losing his money and being given more cash because he does not know he’s a loser.
The Bank’s are directed by people who have entered an area where they have no experience - Remember 1974?
I think we need someone on the other side of this argument. Remember the question - its whether rights issues are good for investors. I’ll interpret that question as - really - are the RBS and HBOS issues good for us. Personally I hold both so have a keen interest, and yes I will be exercising my rights. For me its a no brainer as thats the only way you I back to fair value by buying the discounted rights. The 2nd part of the question is will they do better in the future ie should you put your hard earned £s in ex rights.
My view is that you should. Why?
The argument is that generally speaking rights is putting good money after bad, and in the general case that is probably true. But I am arguing the specific not the general. Specifically HBOS and RBS are cash generating machines that have been stung by securitisation and the lack of transparency and funding assumptions it was based upon. They are not alone - when things were doing well to not dance that dance was seen as craziness in missing the returns. We are all wise in hindsight. For 90+% of their diverse businesses these two banks do very nicely and are seen as being well managed. So if they stop the small bit that killed them why should things not come good. HBOS has a good mortgage book and mortgages will be both better consumer risk managed and more importantly much more profitable in the short term if you have a big enough balance sheet not to rely on securitisation, which of course after the rights issue they will.
Will the banks make some almighty error of catastrophic proportions a la latin american debt or subprime? Probably - but it will not be in mortgages! So HBOS should be just fine, and RBS has a good run. So personally, I think you have extraordinary value so get in there!
I am an RBS holder and have not taken up the rights. In fact, I sold the rights to take more money off the table. My issue with RBS and many other banks is that there is too much uncertainty. I do not feel that the banks have truly come clean with their balance sheets and I this it is prudent to take money out until I can have a higher level of confidence.
Banks balance sheets have been stress tested to with-hold house price falls in the UK of 20% - I think this underestimates potential falls and it could be far worse – the gearing of the banks will kill them.
The losses so far have been mainly to do with leverage and sub-prime. As the western economies move close or into recession, they will start to get real losses from Credit Card defaults, Mortgage default, Personal Loan default. To add to these worries, they have packaged them up in CDOs and this will leverage the problem.
A consumer slow down could cause problems for many companies – esp. retailers, housebuilders etc. Once these companies struggle, their loans will default.
The bigger risk however, arises from where banks can make profit going forward. Think about it. They cannot make money from packaging and on-selling loans. They cannot make money from lending (no one will borrow and defaults will be high). They cannot make money from penalty fees – OFT ruled against this. They cannot make money from IPOs – no companies will float. They cannot make money from Investment Banking – this has been their downfall with the high leverage.
In answer to a comment from Leo Kearse “Don’t forget too that the high PE valuations for banks at the moment are generally based on earnings from before the credit crunch! Forward PE is likely to be much lower” I do not agree. The earnings will be lower, therefore the PE will be higher. This is bad news.
Summing up, I did not take up my rights at £2 but I will not be surprised if I can buy RBS shares at well below this in the future !!!