What’s the right way to handle a Rights Issue?
Nov 15, 2011 at 11:40 am in General Trading by
Every now an again you see a company offering additional shares to existing shareholders in what is known as a “rights issue”. They’re not doing this out of the kindness of their hearts, and you’re not getting something for nothing. So what is on offer, why are they offering it, and what should you do about it?
What’s on offer?
In traditional share dealing terminology, you will be offered the chance of buying — yes, they’re not giving them away — additional shares in proportion to the size of your existing holding; for example the chance to buy 1 additional share for each ten existing shares that you hold. These additional shares will usually be offered to you at a substantial discount to the prevailing share price, as an incentive for you to take up the offer.
You generally have three options:
- Buy some or all of the additional shares that you are offered.
- Do nothing, in which case your ‘right to buy’ will lapse.
- Sell your ‘right to buy’ on to someone else via the market.
Note that whereas in a traditional brokerage account you will be sent a letter detailing your options and asking for your decision, things typically work rather differently in a spread betting account. Typically you will see that the spread betting company will add a separate “XYZ Company Rights” position to your portfolio, which may rise and fall in value as those rights are determined by the market to be more or less valuable, and you might choose to sell on your rights by closing the position if it moves into profit.
Why are they offering it?
If you think back to the big banks in 2007-2008, they instigated rights issues because — quite frankly — they were desperate for capital.
Some companies are not desperate for more money in order simply to stay afloat, but they would like more funds in order to fund the acquisition of a complementary or competitor company.
What should you do about it?
On the face of it, rights issues generally look very attractive. Unlike those who fail to take up their rights, you won’t find your existing holdings diluted when the new shares are issued. If you’re the kind of trader or investor who likes to “average down”, the offer of more shares (or the equivalent in your spread betting account) at a lower price will appeal to your sensibilities.
The downside is that, as a trader, you will know that ‘averaging down’ is generally considered not to be a good idea because you could be throwing good money after bad. Especially when the company in question is issuing more shares precisely because it is in bad financial shape. Just ask anyone who took up their rights in those formerly rock-solid big banks that I alluded to earlier.
A rights issue to fund an acquisition sounds entirely more reasonable, but have you noticed what tends to happen to the share price of the acquiring company when it makes (or even announces) it’s acquisition? That’s right, the price goes down.
The bottom line is that you should be wary of rights issues that look too good to be true. If your ‘rights’ move into profit, sell them on. If they don’t then you might be better off letting them lapse so that you receive any residual value, rather than throwing good money after bad by taking up the rights. Ultimately, the decision is yours.
Tony Loton is a private trader, and author of the book “Position Trading” (Second Edition) published by LOTONtech.