The Rights, Wrongs and Ups and Downs of Rights Issues

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First Group, the transport group with trains and buses on both sides of the Atlantic, announced a 3 for 2 rights issue on 20 May 2013. The day before the price of the share was 223p. While at the same time the company announced it would no longer pay a dividend, the price once the 85p rights issue was taken into account should have meant the stock was worth 135p.

© Image copyright az1172

On June the 17 the price of the share hit 92p.

It is easy to say bad things about a company when reasoning why its share price falls, but in any event the result of a rights issue on the share price should be as simple as calculating the value of the company just before the announcement plus the new cash injected divided by the new total of shares issued. This is how the 135p is derived.

So how did the shares fall so far below this value?

The answer is hard to be certain of and while the following speculation might not be the case in this particular instance, it’s a scenario that can happen.

Rights issues are underwritten. This means the bank advising the company in the rights issue will get paid to take up any shares in the rights issue not bought by investors.

Let us say a company whose share price is 200p is doing a rights issue at 100p and the result will leave the company with a 150p share price. The underwriter will guarantee to buy any shares not taken up at 100p by current investors with rights and will get an insurance fee to do so. The underwriter knows they will be getting 150p shares at 100p so they are happy all ways.

Certain companies have lots of small shareholders who buy their stock for the dividend and aren’t rolling in cash.

These shareholders may not have the money to buy the rights – or the nerve – and the underwriters may end up with a bundle of shares at the end of the process.

If an underwriter thought he might get stuck with 100,000 shares at 100p, they can sell short now at 150p in advance of the issue completing when they will receive shares at 100p. They can lock in their profit and lower the cash they need to make good on their underwriting promise ahead of time.

This is a safe route for them as they are locking in a profit now rather than ending up a long term shareholder.

This will push the current price down. Meanwhile small investors will get more nervous about taking up their rights, so the underwriters might sudden expect they will end up with more shares still at the end of the day and will therefore short the share further, pushing the price down towards the rights issue price.

This can create a downwards spiral, until the share price is near the rights price and far below the correct price.

Brave investors will buy. However it takes a lot of nerve to buy into a share which has fallen out of bed.

Once the rights process is over, the share should bounce back to its projected price of 150p, but it may take a long time to do so because shares that fall heavily can stay out of fashion for a while.

Even so, a rights issue puts a company on a firmer footing and should actually raise the value of the stock above  its new computed value, so a share that falls far to its rights price is a good prospect for investors with longer term horizons and the capital to take a long term view.

 

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