Avoid recent rights issues

Banks and property firms have led a flurry of rights issues recently. But investors should give most of them a wide berth. Tim Bennett explains why.

Hopes that the British economy might have turned a corner have led to a "flurry of rights issues", notes Dylan Lobo on Citywire.co.uk. Leading the charge are banks and property firms, anxious to shore up battered balance sheets with fresh capital. But investors should give most of them a wide berth.

A rights issue is often a last resort. That's because it suggests that cheaper sources of raising capital such as existing profits and cash flow (organic growth), or bank loans and bonds have been exhausted. It gives a company the chance to raise fresh capital from existing shareholders who normally have a 'pre-emptive' right to buy first, assuming this has not already been waived by agreement. So what should you do?

Deciding to 'take up your rights' means you will be asked to pay for new shares, but at a discount to the market price. For example, a one for four rights issue at £2 per share is an offer to you to buy a new share at £2 for every four you currently hold, trading at, say, £4 each. Take up the offer and you can expect the average share to trade at around £3.60 'ex-rights', ie £(16+2)/5. Despite that dip from £4, you've lost nothing prior to the rights issue you owned four shares worth £16 and now you own five worth £18, having paid the company an extra £2.

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However, you may decide you already own enough shares in, say, RBS or Barratt, and don't want any more. In which case, you can opt to sell your rights 'nil paid'. This is usually done automatically if you fail to respond to the rights letter from the company within 21 days. Your rights are sold for whatever a broker can get for them. All other factors that influence a share price being equal, these rights are worth about £1.60 in the earlier example the gap between the ex-rights price (£3.60) and the price demanded for the new share (£2).

Looking at the most recent rights issues, I'm not convinced there are many bargains to be had. "Stockmarkets have gone up too much, too soon, too fast," says New York University Professor Nouriel Roubini. And while the IMF is forecasting a return to growth in 2010, the expected global rate of 3.1% is "anaemic".

Banks and property firms are in a hurry to raise money precisely because they could be battered should the recent "recovery" be derailed. RBS is a typical example. The bank is said to be "weighing up options that could include a rights issue" to raise £3bn-£5bn. But as one investor put it on FT.com, any attempt to do so is less a final solution to its woes than "the tip of the iceberg". We'd avoid such issues while the recovery remains doubtful.

Warren Buffett "uncovers hidden gems", says Chris Menon on Motley Fool, because he favours return on equity profits after interest and tax divided by shareholders' equity from the balance sheet to other value measures, such as price/earnings or price/book ratios. That, says Jack Hough in Smart Money, has led two finance professors to a powerful new stockpicking system.

The key to it, say Washington University's Long Chen and Lu Zhang, is realising that "most successful companies earn a lot while using very little". So you should use measures that focus on that, rather than on a firm's share price that can be held ransom to Mr Market's rapid mood swings.

So they start with return on assets. That's profits after tax (say £75m) divided by balance-sheet net assets (say £500m) multiplied by 100 to give a percentage (15%). The higher, the better. Next they look at stock levels, as "low or shrinking inventories often indicate an efficient company". Lastly, they check the latest change in capital expenditure (by comparing this item in the last two cash-flow statements). Low or shrinking capital expenditure is more good news, as "frugal firms don't spend as much" and return more to shareholders.

It seems to work. Between 1972 to 2006 this approach "all but snuffed out" the predictive power of "share-price momentum, asset growth, earnings growth" and "other stockpicking anomalies", says Hough. But he warns: "no formula can sum up everything that goes into judicious stockpicking".

Nonetheless, the screen throws up two stocks that cut the mustard on other measures too. The first is software firm Microsoft (NASDAQ: MSFT). It produced a 19.3% return on assets over the last 12 months, shrank stocks by 27% and reduced capital expenditure by 2%. The forward p/e is 14 and the yield 2.2%. Discount US clothing seller Aeropostale (NYSE: ARO) managed a return on assets of 28.3% last year, while reducing stock by 4% and capital expenditure by 55%. Its p/e is 13. As Forbes notes, last-quarter earnings rose 84%, making it a "best buy".

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.