Shareholders Beware! Corporate Rights Issues Could Lose You Money

By: MoneyWeek

There's about to be a rush of companies issuing new shares. And it could well be a trap for investors.

Companies use rights issues to try to tap their shareholders for cash by offering them first dibs on new stock offerings, normally at a chunky discount. And some analysts reckon this dash for cash is a harbinger of better times ahead. (More on that bullish view in a minute).

But this means more shares around - in markets already in dire need of help. Further, with many businesses so short of money, shareholders' funds are a last resort.

Don't get caught out by companies in trouble…

Companies across the continent rush to raise cash

Interesting. Here we are in the middle of a big bear market, yet according to Bloomberg the supply of shares in Europe is actually increasing for the first time since 2005. Some firms like zinc producer Xstrata and ceramic linings maker Cookson have already said they're raising extra cash by selling more stock this year. It could be the start of a major trend. Goldman Sachs forecasts that companies across the continent are looking to raise some €300bn in 2009.

"Some of Britain 's biggest companies including Lakeside owner Liberty International and bookmaker William Hill will announce rights issues to raise billions of pounds within the next few weeks", says the Sunday Telegraph's Garry White , with Hovis and Mr Kipling cakes owner Premier Foods "planning a £400m rights issue alongside its results".

Rights issues: what should we make of it all?

Several analysts think the imminent cash raising rush is a bullish sign. Looking at European companies with rights issues over the past decade, 72% of them improved their share prices in the next six months, says Royal Bank of Scotland . "Rights issues contain the seeds of their own success", says Gartmore's Adam McConkey, "improving prospects will see a significant improvement in the share price". And Raiffeisen Capital's Norbert Janisch says: "if a company gets into a position where it needs a rights issue, if it acts swiftly, the outcome can be positive".

Sorry to pour cold water on all this optimism, but pull the other one.

UK companies are right under the financial cosh at the moment. As we pointed out in this week's cover story week: Seven companies that will prosper in the recession (If you're not a subscriber, get your first three issues free here ) the latest numbers from the Bank of England showed that business cash is fast running low.

Corporate bank deposits dipped by nearly 5% in 2008 and the speed of the decline is accelerating. The year's final quarter saw a near-2% drop, the biggest fall since the Bank's records began over ten years ago. With the recession getting tougher, business cash balances can only get even thinner.

Rights issues are the last resort

So why are all these companies rattling the tin in the direction of shareholders now, rather then when their shares were two to ten times higher? (No misprint – Premier has plunged over 90% within the last two years.)

Either their corporate advisers didn't think of the idea a lot earlier, in which case they should be sacked, or the companies themselves weren't quite so desperate for money then. Or maybe both. But the need for money must be becoming pretty serious.

And why don't these companies have a bash at raising the cash elsewhere? Presumably the banks won't play ball – after all, they've enough troubles of their own without having to worry about the tedious business of lending to customers – but isn't there talk of investors supposedly showing a renewed appetite for corporate debt?

Some firms have managed to refinance their balance sheets by borrowing in the bond market. But it's not exactly been easy. They've had to pay top dollar for the money. What's more, the market's getting more nervous again – and much more selective. Virtually unnoticed, the cost of insuring against non-payment by some of the riskier corporate bonds has jumped in the last week almost back to its all-time high of two months ago. Default fears are back in a big way.

It all adds up to rights issues being more or less the last resort. And while companies that do succeed in cadging some extra cash off their shareholders may see a short-term share price bounce, it's often driven by relief that these firms won't be running into more trouble for the moment. And in this market, rallies soon fizzle out.

How to make sure you don't get caught out

So what should you do if one of the companies in your portfolio offers you an apparently tasty opportunity to 'snap up' some new shares at a big markdown on the current price?

Be very careful. Don't be tempted just by the discount. It may look large just after the rights announcement, but then the share price could well drop back a long way. If you think the company's in good nick, and isn't in dire need of the extra cash, it might still be worth subscribing for the new stock. But if the firm's finances were looking dodgy pre-issue, it's probably best to dump the shares anyway. In that case, if the price rises on news of the rights, cash in by getting out.

And for an example of how wrong things can go, remember HBOS. Its £4bn July 2008 rights offer made history by achieving the lowest take-up in Europe this decade, as shareholders claimed only 8% of the stock on offer after the shares fell below the rights price. Not only did the bank nearly go bust then, it's now dragging down Lloyds as well.

Don't get caught out like that...

By David Stevenson for Money Morning , the free daily investment email from MoneyWeek magazine .

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