I’m rather surprised by the number of hits I’m still getting on a previous post, which noted the unnecessary complexity of the upcoming Lloyds rights issue and the way it’s been presented. I rather thought the weekend papers would clear the matter up, so was unsurprised to read the Guardian Money front page headline “Buddy, can you spare me £13.5bn?”. I immediately followed the injunction “>>Pages 4-5” and fast-forwarded to read Jill Treanor’s examination of the “implications for small shareholders” and Patrick Collinson’s suggested “plan of action”.
I have to say I was rather disappointed.
Collinson suggests that:
“You got some Halifax shares when it floated. Now we at Lloyds want you to cough up a couple of hundred quid (we won’t tell you the exact sum till later)…”
Now it simply isn’t true that Lloyds haven’t advised the exact sum investors will have to “cough up” (though they could have been clearer). As I pointed out last time, it’s quite simple: Lloyds wants £13.5bn, which will be divided equally amongst the ~27bn shares in circulation. That’s ~50p a share. If you own 1000 shares you’re going to be asked to put in £500. How many new shares you’ll get and at what price each is yet to be determined.
This is actually a step forward in the organisation of rights issues. The problem is that when a company announces it is going to sell a lot of shares, the price tends to fall – supply and demand – since not every share owner will be able to and want to put more cash into Lloyds equity. By delaying the announcement of the price of the new shares until the last minute, Lloyds has somewhat reduced the risk of the share price falling below the rights issue price, which would be a disaster, since, if you could just buy shares in the market for a lower price, there would be no point taking up the rights issue. The under-writers would end up with all the new shares.
What worries me most about Collinson’s comment piece and Treanor’s Q&A is that they omit part of the case for participating in the rights issue. What I’m about to say should not be construed as financial advice, but there are obvious reasons why a company’s share price might be depressed ahead of a rights issue and that in general a rights issue may be a good opportunity to invest.
The key point is supply and demand for the shares, that is, precisely what Lloyds is worrying about and the reason for the confusion about the offer price for the new shares. Many investors – funds or individuals – may simply be unable to put more money into Lloyds shares. They may just not have the cash. Or, especially if they’re a fund, they may not want Lloyds shares to rise as a proportion of their portfolio. This could even be against the rules of the fund.
Of course, some investors, such as index tracker funds, may be compelled to increase their holding in Lloyds in line with the increase in volume of its equity. But it’s difficult to think of a fund that would be compelled to take up more than its share of rights.
Therefore, it’s often argued, a rights issue is a good time to buy, because there is a surplus of sellers of the stock.
As Jill Treanor points out, you can sell some or all of your rights in the market, for example, to raise enough cash to take up the rest of your rights, a practice known as “tail-swallowing”. Such selling activity will tend to make the rights cheaper. But it’s important to understand that if the price of the rights falls, then so does the price of the existing shares. The reason is the (arbitrage) opportunity to simply sell shares and buy the rights.
Example: To simplify a little, say Lloyds shares fall to 60p when rights have been given to all the shareholders. The rights might entitle you to buy new Lloyds shares for 40p each (so you’d get 5 for every 4 shares you held at the qualifying date for the rights issue) so should sell for about 20p each (since once you’d put in the 40p you’d receive a new share exactly equivalent to the existing shares). If so many people sell their rights that the price is not 20p but drops to (say) 18p, then someone could sell shares for 60p, buy rights for 18p, subscribe to the issue for 40p and make (60 – 18 – 40)p = 2p a share. Do this for a few million shares and you’re building up a tasty bonus pot! What happens when people sell the shares to buy the rights, of course, is that the share price tends to fall until the price of the shares and the price of the rights are aligned again.
So, according to this argument, it may be a good time to buy Lloyds shares, e.g. by subscribing to the rights issue.
It might also be worth noting that Lloyds stated that it will not pay a dividend for 2 years. This may be another reason why some investors (income funds) will not want to hold the shares, though they may already have sold their holdings in the stock.
Of course, there are many reasons why it could turn out to be a bad time to buy Lloyds. They might screw up. Or we might experience the dreaded double-dip recession. And if so many people decide it’s a good time to buy Lloyds, this will push up the price and make it a bad time to buy! Though it is the largest rights issue in the UK to date…
At the end of the day, investors must make up their own minds, and, as I say, I’m not providing financial advice. Patrick Collinson (or his editors) are bold enough to allow themselves a headline “Lloyds looking unattractive” (or “Lloyds rights issue looks distinctly unattractive” in the online version). I just feel investors might also want to take into account the argument that rights issues can be a good time to invest.
Disclaimer: I worked for Lloyds in the early 1990s and own some Lloyds shares.