This article on rights issue value investing was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer’s Multiple strategy in his personal account. Article image (Creative Commons) by Rawpixel, edited by The Broken Leg
Is value investing an art or a science?
While there are many strategies that fall under the value investing umbrella, the one thing they all have in common is that they all can be considered somewhat off the beaten track — and none more so than rights issue value investing.
The true value investor has the creativity to see and recognize a value opportunity and the commitment to a scientific method to stay composed throughout the process.
Rights issue value investing is no different.
What Is Rights Issue Value Investing?
A rights issue is a corporate event whereby a company, seeking to raise cash, offers its existing shareholders the opportunity (or right, which may be traded on an exchange) to purchase newly created shares at a discounted price. A rights issue serves as an alternative to cash raising through debt. In addition, it provides value investors with a golden opportunity.
Here to enlighten us as to why this might be is none other than Seth Klarman:
“Rights offerings are more esoteric than many other investments and for this reason may occasionally be of interest to value investors. Some rights offerings present attractive bargains, but many are fully priced or even overpriced. Investors may find this an interesting area to examine but as usual must do their homework.”
In practice, a rights issue provides a value investor with an opportunity when the share price fails to value either the stock or the right (or both) accurately.
However, as Klarman says, rights issue value investing is by no means a sure thing when it comes to sourcing an undervalued security. However, this fact in itself makes it only more likely that opportunities within this technique will exist. For undervaluations to exist, market interest must be limited. This is what makes special situations such as rights issue value investing such fertile ground for value investors.
Why Does Rights Issue Value Investing Work?
Now that we know what the rights issue value investing strategy is, it would be great if we could find out why it works. Fortunately, Klarman is still on hand to explain:
“Unlike a typical underwritten share offering, where buying by new investors dilutes the percentage interest of current shareholders, in a rights offering shareholders are given the opportunity to preserve their proportional interest in the issuer by subscribing for additional shares. Those who subscribe retain the same percentage interest in the business but have more of their money at stake. Investors who fail to exercise their rights often leave money on the table, creating an opportunity for alert value investors.”
So, the very event that is a rights issue creates the prospect of a value opportunity. A rights offering allows a company to create new cash on its balance sheet by offering new shares to its existing shareholders at a discount to the price it trades at on the open market. Should existing shareholders subscribe to 100% of the issue, they will all own the same proportion of the company as they did before. In this way, shareholders may feel compelled to subscribe. However, if they do not subscribe — as is often the case — the rights issues become available to outside investors. It is at this point that either the right or the underlying share becomes a potential value play. In other words, the irrational behaviour of the existing shareholders provides us with the opportunity for a low-risk profit.
A Practical Example
This scenario is best conveyed by an example. Fortunately for us, Klarman provides one:
“By way of example, assume XYZ is a closed-end mutual fund with one million shares outstanding, which trade at a price equal to the fund’s net asset value of $25. Further assume that XYZ, seeking to raise an additional $15 million to take advantage of market opportunities, issues every holder a non-transferable right to buy another XYZ share for $15. If all holders subscribe, then immediately after the rights offering XYZ will have two million shares outstanding and $40 million of total assets, or $20 per share. If holders of 50,000 shares do not exercise their rights, while holders of 950,000 shares do, the 1,950,000 shares outstanding after the rights offering will have a net asset value of $20.13. The investors who subscribed will have an average cost of $20 per share, while those who did not will have an average cost of $25. Since nonsubscribers will suffer an immediate loss of almost 20 percent of their underlying value, all holders have a powerful incentive to subscribe. Some rights offerings give holders the opportunity to oversubscribe beyond their own proportional interest for shares that others do not buy. In the case of XYZ, investors who chose to oversubscribe for the 50,000 shares left unsold at the original offering could have made a quick $250,000 buying those shares at $15 and promptly selling them at the pro forma net asset value of $20.”
As Klarman shows, in the case where less than 100% of the issue is subscribed to by existing shareholders (while in this example existing subscribers chose to oversubscribe, the result would be the same), an immediate risk-free opportunity emerges for the value investor. Of course, this is a very specific example involving a closed-end fund.
However, the rights issue value investing strategy can just as easily be applied to that of a standard publicly traded company. In such a case, the only variable that would change would be that an investor would be buying the stock of a company, rather than the unit/share of a fund. In both cases, the entity would have a market value, and in both cases, the issue would be made at a somewhat discounted price to that value.
How to Approach a Rights Issue Value Investing Opportunity
Though this all sounds simple, the rights issue value investing strategy won’t always be this easy — and, unfortunately for us, the above example is an oversimplification of how it works in reality.
Before we are ready to begin investing in rights issues, we need to understand the key measurables and dates with respect to rights issue value investing.
When a rights Issue is announced (the announcement date), its price tends to immediately trade higher. This is due to the fact that the price now includes both the value of the share and the rights to additional shares that come with it. This is known as the cum-rights price. The cum-rights price will trade as such until the ex-date.
Once the ex-date is reached, the new price (ex-rights price) represents the share price without the rights attached. At this point, the rights themselves trade as securities. These rights can be purchased and sold on the stock exchange just like a regular stock.
It is at this point that we value investors should begin to take an interest. However, we must remain alert — rights will only trade as standalone securities for a couple of weeks before they convert to ordinary shares.
The easiest way to view these rights is as in-the-money options — and the easiest way to value them is by considering whether the combination of the price paid for the right and the subsequent discounted share price is less than the current share price. Theoretically, the two should be equal, but in practice, they often are not. By pouncing on these price discrepancies, value investors can make large profits for themselves.
Klarman, again, provides a great example of a case — Consolidated Oil and Gas, Inc. — that played out this way:
“Under its terms, shareholders of Consolidated were offered the right to purchase one share of Princeville for each share of Consolidated they owned. The initial offering price, $3.25 per share, was arbitrary, according to the prospectus, and considerably below Consolidated’s cost basis in Princeville.
When the rights started to trade, little information had been released by Consolidated Oil and Gas concerning Princeville. The prospectus was apparently not yet publicly available. In the absence of publicly available information, some rights traded for as little as 1/32 and 1/64 of a dollar per right. Alert investors willing to make an educated guess were able to earn an enormous profit on this obscure rights offering; upon completion of the offering, the market price of Princeville quickly rose above $5 per share. Rights that traded as low as 1 1/2 cents rose in price to nearly $2 only a few weeks later.”
While this was a special case, whereby there was no publicly available information to work with, the point is that alert investors had the opportunity to take advantage of the market. This is the essence of what value Investing is all about. The market provides constant opportunities for us to capitalize upon such situations, and rights issue value investing is but one example of these opportunities.
Rights issue value investing is an example of a special situation value strategy. Like all special situation strategies, it requires vision to identify it and both scientific persistence and discipline to execute it. In this way, rights issue value investing — and value investing more broadly — can be said to require both artistic and scientific disciplines. In other words, true value investing requires us to apply both sides of our brains. Keep this in mind (or rather, let it out!) when you consider your next value investment.
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