Post-Secondary Education : Stock Prices Often Suffer for Years After Such Offerings

Owning stock in small, fast-growing companies is sometimes like drinking a frosty glass of iced tea on a hot afternoon. At the peak of enjoyment they both tend to become diluted and end up a watered-down mess.

In the case of corporations, dilution comes in the form of a secondary, or “follow-on,” stock offering. And it can really ruin your day--or decade.

According to recent research by a couple of finance professors, the typical company that raises fresh capital via a secondary stock offering will sharply depress shareholders’ returns in the five years after the offering.

The findings are especially poignant given the record level of secondary stock offerings last year.

Most veteran investors are already familiar with the sinking feeling that follows the announcement by a public company that it plans to offer more stock to the public. Those companies commonly see their share price drop a quick 5% as investors react to the dilution factor: Future earnings will be spread over a greater number of shares.

What is little understood, however, is secondaries’ long-term depressive effect on prices.

The numbers in the research are stunning. Jay Ritter of the University of Florida and Tim Loughran of the University of Iowa report in a recent Journal of Finance article that the average gain in the stock price of a company making a secondary offering is only 7% per year during the five years after the offering, compared with a 15% annual return for firms of the same market capitalization that don’t issue more stock.

Ritter and Loughran offer at least two reasons for the plunge in shareholder return.

They note that their research shows the abysmal post-secondary-issue returns follow lofty price gains averaging 72% for the issuing companies in the year prior to the new stock sale.

A rising stock price, the professors said, probably fools too many corporate managers into thinking they’re geniuses who can do no wrong. The managers often fall victim to a “growth fixation”--an ailment that impels them to invest heavily in expensive new production capacity at precisely the wrong time in their industrial cycle.

“Managers might think, ‘Things are going well, let’s expand.’ But then everyone else in their industry is expanding too, there’s suddenly too much capacity, and the next thing you know, there’s a price war and lower margins and their rosy scenario never happens,” Ritter said in an interview.

On the other hand, the professors suggested, it also could be true that some cagey corporate managers recognize when their stock price is overvalued and issue new stock simply to take advantage of the market inefficiency to line their pockets.

Getting a corporate manager to admit to that might be another matter. “Find me one CEO who thinks that their stock is overpriced!” said Walter Cruttenden, an investment banker in Irvine. “But clearly if they’re going to issue shares, they’re going to try to do it at the highest possible price.”

There are, of course, many good reasons besides the construction of new facilities for a company to issue more stock. When a small firm increases the number of its shares, for instance, Cruttenden notes, large institutional money managers can buy significant stakes on the open market without driving the stock price up.

And arguing against secondary stock offerings almost sounds un-American: Many companies, after all, successfully put new capital to work, building much bigger--and more profitable--businesses over time, enriching shareholders.

Still, the new research appears to present a clear message to investors, according to William G. Christie, a professor of finance at Vanderbilt University in Tennessee.

“If a company in which you hold stock is offering a secondary, get out--and consider selling short,” said Christie, who specializes in the study of small stocks. “It’s likely not only to underperform in the long term, but the offerings’ negative effects are initially underestimated by Wall Street.”

The mechanics of secondary offerings contribute to the problem. Here’s how the game typically works, according to Howard S. Jacobs, an attorney at the New York firm Rosenmann & Colin, which specializes in making the deals:

A company with a good business plan first acquires money from, say, a venture capital firm. The next time it needs cash to grow, it might arrange so-called mezzanine financing from a bank.

Then if it launches a hit product and starts to grow like mad, it might seek the money for a new plant or enhanced marketing by issuing stock in an initial public offering. The new stock is typically issued at a price-to-earnings ratio 15% to 25% lower than securities of similar, already public companies, to compensate potential shareholders for the risk. That discount is what typically accounts for the quick pop in price when new issues hit the market.

For the company’s next expansion, many investors naturally would prefer that it use internally generated cash. If profits aren’t sufficient, however, Jacobs said, managers typically call up their investment banker and ask him or her to hawk more shares.

The initial market decline in a stock’s price after a secondary offering comes partly because the investment banker, who is also usually the stock’s market maker, receives an 8% discount on new shares to do the deal. “If they’re only willing to give the firm $18.40 for a $20 stock, it tends to move down, because the market tends to perceive that is its real value,” Jacobs said.

The longer, sustained post-secondary slide in stocks’ prices, according to Loughran and Ritter, is a result of the fact that the operating performance of issuing firms tends to peak at about the time of the offering.

Using a sample of 1,338 companies that made secondary stock offerings from 1979 to 1989, they found that the median profit margin in those firms decreased from 5.4% in the first year of the offering to 2.5% four years later. The median return on assets fell to 3.2% from 6.3% over that time.

Investors, the professors conclude, are too gullible and optimistic about the prospects of these companies--and underwriters don’t do them any favors by having in-house research analysts promote the stock with optimistic forecasts.

How can you protect yourself? The answer is surprisingly simple, though it’ll take a bit of effort and skepticism.

Companies are required to file a prospectus with the Securities and Exchange Commission before they make any new offering of stock. It’s a good idea even for investors who don’t plan to buy the new shares to obtain the prospectus because companies must detail, in a section headlined “Use of Funds,” exactly what they plan to do with the money. Managers must also describe the dangers of their plan in a section called “Risk Factors.”

“Don’t be smug about your investment. Get their statement and read it carefully,” Jacobs said.

The filings, typically called S-1, S-3 or S-8 registrations, are available for free on the Internet from the SEC’s Edgar database (https://www.sec.gov/edgarhp.htm).

To get a heads-up that a secondary might be in the offing, also be sure to read the “Liquidity” section of your company’s 10-Q filing each quarter. Sometimes companies will indicate, near the end of that chapter, whether they have enough money to keep going. Any equivocation might be a sign that a secondary lies ahead.

Take, for instance, a company in which I own 100 shares: Massachusetts-based SpecTran Corp. The liquidity statement in its fiscal third quarter 10-Q issued in November declared, following a long discussion of bank debt: “The company is also exploring other ways of financing its capacity expansion.”

On Jan. 9, after a fourfold stock price increase over the prior year, the fiber-optic cable manufacturer announced it would offer 1.8 million new shares to the public to raise money for a new plant that would double its manufacturing capacity. Traders the next day lopped 9%, or $2.50, off SpecTran’s $23 share price; on Monday the stock closed at $22.50.

Incidentally, there are two types of secondaries that wave big red flags. One, called a Regulation S offering, allows a company to offer new shares at a steep discount of 20% to 30% to investors overseas. These shares can be sold back in the United States after 40 days, and often seriously depress prices when they flood in.

“A Reg. S offering shows that a company is desperate for money and no bank or U.S. investment house will take a risk on them,” Jacobs said. “Look at the terms: If they’re significantly below market price, get out now and ask questions later. Usually it means the company is in a little bit of trouble.”

A somewhat less troubling secondary, called a Regulation D offering, allows a firm to raise cash quickly by selling shares at a 20% to 30% discount to an American fund. These shares must be held for two years before they’re resold, and can also depress prices when they flood onto the open market.

Street Strategies explores investment tactics. Jon D. Markman is a Times staff writer. He may use strategies described in the column. He can be reached at jon.markman@latimes.com

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Secondary Boom

Although initial public offerings get all the headlines, secondary offerings are much more common. Both have risen sharply in the six-year bull market, except for a blip during 1994.

Money raised by U.S. companies in secondary stock offerings per year:

1990: $9 billion

91: $31 billion

92: $33 billion

93: $44 billion

94: $28 billion

95: $52 billion

96: $65 billion

Money raised by U.S. companies in initial public offerings per year:

1990: $4.5 billion

91: $16 billion

92: $23 billion

93: $34 billion

94: $23 billion

95: $29 billion

96: $50 billion

Source: Securities Data Co.