Tuesday, January 12, 2010

More on Dilution

Rights issue sucks! Let’s see how this works:

Imagine you are the sole owner of Company ABC. It's better to think as a sole owner, it makes things clear.

So you put in $10mn capital to start the co. You list the co. and now own 1mn shares of $10 each. ie mkt cap of your co. is $10mn. Then you appointed a CEO to help you run the business. He lost $8mn, well partly bcos of the crisis, partly bcos he was not prudent and expanded to rapidly during the heydays of 2006-07, partly bcos he paid himself and his kakis $1mn over the past few yrs.

The share price plummet to $3, ie mkt cap is now $3mn and the capital is now $2mn. So the CEO announces a rights issue of $10mn, 5mn shares to be issue at $2, that’s 33% discount to today’s price of $3. Do you:

A. Rejoice bcos now you will own 6mn shares of your co. at an average of price $2+ but the share price is $3 (btw you paid $20mn in total, but the value of your co. is now only $12mn)

B. Or you curse the manager for losing most your capital, fire him and sue him in court to try to salvage part of the lost $8mn.

Rights issue is a form of dilution: if you do not take up the issue, your stake in the co. is reduced. If you do, you just gave money to a crappy management who lost the original capital in the first place.

Some other companies do outright secondary offering where the original investors suffer if they do not participate.

Management will often say that raising capital is the prudent thing to do to keep the company as a going concern. But who jeopardized the firm as a going concern in the first place?

Of course, in the stock market, where there are a million participants, Genius Ah Beng could have waited for the shares to fall to $3, participate in the rights issue, bring down his buying price to $2+ hence making a arbitrage since today’s share price is $3.

But that does not change the fact that management screwed up in the first place.

If you are a value investor, you should not be giving money to a management who goes cap in hand whenever he gets a chance! (And it’s always a HE, not a she). The SHE gives out the money magnanimously, every time!

So pls beware of companies that to serial rights issues!
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