Rogue Missives Friday,  April 11, 1997

Most investors approach initial public offerings (IPOs) with a fair degree of skepticism. Who can blame them? After all, new issues tend to wildly underperform comparable stocks over a five-year period.

What investors are much less likely to realize is that the same market dynamics that lead new issues to do poorly are also at work when other companies offer new shares. In fact, firms that issue additional shares, either as part of a merger or as simply a way to raise additional capital, also significantly underperform their peers over the ensuing five-year period.

These surprising observations come from two recent papers co-authored by Tim Loughran, a finance professor at the University of Iowa. The first, called "The New Issues Puzzle," appeared in The Journal of Finance (March 1995) and was co-authored by Jay R. Ritter, a professor at the University of Florida. It examines 4,753 IPOs and 3,702 seasoned equity offerings (SEOs) made between 1970 and 1990.

The second, entitled "Do Long-Term Shareholders Benefit From Corporate Acquisitions?" and co-authored by Loughran's Iowa colleague Anand M. Vijh, will be published in a forthcoming issue of the same journal. It examines 947 corporate acquisitions conducted between 1970 and 1989 and shows that all-cash tender offers, particularly hostile ones, led to outstanding long-term appreciation in the acquirer's stock price. This was in stark contrast to the poor performance of companies that used a stock swap to orchestrate a friendly merger.

Both papers are pure dynamite and deserve to be widely known. Individual investors may find they can save themselves a great deal of money and grief as a result. The conclusion of each might be summed up by a line from the 1995 paper. "Investing in firms issuing stock is hazardous to your wealth."

THE NEW ISSUES PUZZLE

Many investors realize that a company looking to go public tries to select a favorable time to do so. The current owners, after all, want to raise as much capital as they can while diluting their ownership interest as little as possible. They're looking to sell high.

That's why initial public offerings (IPOs) flourish during bull markets, when investors seem gaga over equities and are more willing to pay up for new issues. It's also why companies tend to go public when their business has been particularly strong, and the underwriters can make the case that the corporation's future looks bright.

The Loughran-Ritter paper, like numerous other academic studies, shows that the honeymoon is short-lived. The professors took a non-issuing company with the market value closest to but higher than that of the issuing firm and used it as a match. Each was followed for five or more years following the first day of the IPO, as if a buy-and-hold strategy had been adopted. The results are striking.

Discounting the virtually guaranteed first-day gain for investors lucky enough to get a piece of the offering, new issues generally do merely as well as matching firms for the first six months. After that, insiders can and often do start selling some of their restricted shares. At that point, look out.

In the six months following the offering, IPO firms in the study actually lost 1.1%, versus a 3.4% gain for the matching firms. The new issues continued to underperform over the next three years, with the gap narrowing but persisting well into the seventh year following the IPO. During the 20-year period the researchers studied, the average annual return over the five-year period following the IPO was 5.1% for the new issues and 11.8% for the comparable firms.

The message ought to be clear: IPOs only take place when the market is prepared to accept a new equity that is overvalued relative to other comparable stocks already on the market. How, then, do these offerings get done at such relatively unattractive prices?

As Loughran and Ritter put it, "the prior rapid growth of many of these companies makes it easy to justify high valuations by investors who want to believe that they have identified the next Microsoft." As they argue, though, investors consistently overestimate their chances of finding a big winner. "It is the triumph of hope over experience."

All of this is something like the conventional wisdom when it comes to IPOs. But Loughran and Ritter break new ground with the finding that what applies to IPOs also holds true for SEOs, or those stock offerings made by companies that are already public. "Our evidence is consistent with a market where firms take advantage of transitory windows of opportunity by issuing equity when, on average, they are substantially overvalued."

The professors found that companies issued new shares when they were coming off big years. Indeed, the firms had experienced, on average, a stunning total return of 72% in the prior year, with about half of the gain accounted for by a market runup and the other half by the issuer outperforming the overall market.

In the five-year period after the offering, the issuing firms turned in merely a 33% cumulative investment return, far below the 93% return for matching firms. The average annual return for the issuers was just 7%, less than half the 15.3% return of comparable companies, mirroring the pattern of underperformance experienced by companies that had recently gone public.

Loughran and Ritter found that the results could not be explained simply by a hot stock stalling after a great run. If one begins the five-year comparison six months after the offering occurred, issuers had only a 26% return, versus 98% for the matching firms. On the other hand, about one-quarter of the underperformance could be explained by the fact that the issuing firms generally had low book values relative to their market value. In other words, at the time of the offering, they were overvalued by one conventional criterion.

These numbers suggest that the new issues puzzle can be explained, in part, as a simple valuation problem resulting from a double failure in the supposed efficiency of the market. The problem begins when the market values issuing firms based on the false assumption that transitory improvements in operations will persist indefinitely.

This mistake ought to be corrected when the share offering is announced. But the prices of stocks in this survey declined, on average, only 3% after the announcement. Loughran and Ritter calculate that the shares were overpriced by 49% to begin with. So for the new issues to be a good buy relative to comparable firms, the stock price would need to drop by one-third from the level attained at the time of the announcement.

Though many investors fear the dilution of an additional stock offering, the paper's stark conclusions have perhaps been missed by the market because the offering firm does not begin to underperform until six months after the new shares hit the market.

In an unpublished follow-up paper, Loughran and Ritter offer some details about how much operating performance falls off following an offering. For example, a sample of 1,338 SEOs showed that median profit margins dropped from 5.4% the year of issue to 2.5% four years later; the median return on assets fell from 6.3% to 3.2%; and the median ratio of operating income to assets fell from 15.8% to 12.1%. The post-issue deterioration is worse for small companies (with assets between $20 million and $55 million), suggesting that small, fast-growing companies are the most susceptible to the post-issue underperformance.

Most interesting, the fastest growing companies perform the worst following an offering, turning in sales gains 9.1% below that chalked up by the slow-growers. Companies with the fastest growing capital expenditures actually underperform the slow-growers by 11.6%. Investors expecting continued strong growth see the fall-off in operating performance, realize the growth prospects were exaggerated, and drop the stock's market multiple so that it's in line with the more subdued expectations.

The authors suggest that both the market and a company's managers believe the increased capital investment will keep sales and earnings booming. But the return on these investments is actually negative. Consistent with this misperception is that corporate insiders are oblivious to the connection between the issuance of more shares and long-term underperformance. "[F]irms in which insiders are net buyers underperform just as severely as those where insiders are net sellers," notes the 1995 paper.

It's likely that some of the post-issue underperformance comes from overly optimistic managers using the new capital to diversify into businesses in which they have no experience or to undertake ambitious expansion plans that leave a firm with the kind of excess production capacity that takes years to grow in to.

Of course, some companies do issue new stock and yet continue to perform quite well. In a phone interview, Loughran suggested one reason why companies become exceptions to the rule of underperformance. "The firms that don't spike R&D and capital expenditures, that is, don't invest in projects right after getting this cash infusion, tend to do much better than those that do," he said.

These companies may simply be getting the money while it's cheap and readily available. Indeed, one might suggest that such restraint signals the overall quality of a company's management team: they're not going to spend your money just because they have it.

ACQUISITIONS: STOCK VS. CASH

The recent Loughran-Vijh paper on acquisitions extends the findings from the earlier paper into even more startling territory. The authors found that firms that use stock to acquire a target company also turn in miserable five-year returns, whereas companies that use cash greatly outperform matching companies that have a comparable size and book-to-market ratio.

Let's assume the deal is done. During the 20-year period the authors studied, the five-year, buy-and-hold return for all acquirers was 88.2%. That's good but not as good as the 94.7% return chalked up by the control stocks. But a real disparity becomes apparent once you consider the form of payment. Companies that use their stock as currency turn in just a 61% five-year return, whereas firms that do all-cash deals end up 113.2% ahead five years down the road. (Acquirers that use a mixture of cash and stock score a 102.1% gain over the same period.)

The disparate performances become even more stark once you consider differences in the mode of acquisition. Acquirers that use cash as part of a hostile tender offer register a whopping 145.6% five-year return, far exceeding the 97.7% return of companies that use cash to acquire shares in a friendly merger.

Of course, target firms typically do see a run-up in price prior to an acquisition becoming effective. Loughran and Vijh find that the abnormal return during this period is about the same for all-cash offers (26.1%) as it is for stock acquisitions (25.1%). However, the cumulative return from the period before the announcement of the merger or tender offer to the point five years after the effective date of the acquisition can differ substantially.

Targets of stock mergers show long-term returns 14.9% in excess of the matching stocks. Shareholders of companies acquired in cash tender offers see long-term returns 138.3% above that turned in by matching stocks, that is, if they use the cash to buy the acquirer's stock. The reason for the discrepancy is that after the acquisition occurs, the companies involved in stock mergers actually underperformed the matching stocks by 24% whereas firms that had launched all cash tender offers outperformed those control stocks by 70.3%.

The authors thus arrive at this advice for investors. "The target shareholders who receive acquirer stock in exchange for their holding should sell out for cash when they receive that stock. Shareholders who receive cash in exchange for their holding should go to the market and buy the acquirer's stock."

These results lead to several conclusions about acquisitions that owe much to the earlier Loughran-Ritter paper on stock offerings. As Loughran explained in the interview, "Imagine that your stock is trading at $50. You're the manager, and you know it's worth $100. Would you issue stock? No way. But what happens if you knew it was really worth $10. It's the first thing you'd be doing. You'd be going out and buying companies."

Just as an SEO should alert investors to the likelihood that a stock is overvalued, so too should an acquisition involving a stock swap. The company is, in effect, selling new shares and using the proceeds to purchase the target firm. As the authors put it in the paper, "Stock acquisitions can be viewed as a combination of two events: first, a stock issue, and, second, a merger or tender offer." On the other hand, companies that use cash to make acquisitions are signaling that their stock is undervalued.

Despite all the hoopla about mergers leading to synergies and cost-savings from combining administrative operations or sales forces, the evidence for the period 1970 to 1989 suggests that, in general, mergers "are not in the best interests of shareholders." Many investors feel ambivalent about hostile tender offers, but the Loughran-Vijh study makes a powerful case for them. These all-cash deals are the ones most likely to benefit investors in the long run.

That's because tender offers usually lead to changes in the target company's top management and, often, to improved operations. Indeed, one 1991 study showed that two years after such takeovers, executive changes had occurred at 61% of the acquired firms. A hostile, all-cash tender offer thus signals two distinctly optimistic opinions. First, the acquirer believes its stock is undervalued. Second, this company is so certain it can improve the target firm's results, it's willing to use cash to make the deal happen.

What may especially interest investors is that many of the kinds of mergers taking place today have faired quite poorly in the past. The authors found that the larger the target firm is relative to the acquirer, the worse the long-term stock performance. In fact, companies that acquired firms that were two-thirds their size or bigger actually saw their stock underperform the stock of matching firms by 47.4%.

Loughran explained that when a company's stock is really overvalued, it's most likely to use that stock to acquire a very large firm. The relative size of the target, then, may signal the degree to which insiders consider their company's stock overvalued.

An obvious question is whether the results from these studies can really aid investors today. Conglomerates like ITT still ruled the roost during the 1970s. Throughout the 1980s, huge American firms such as AT&T <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:T)") else Response.Write("(NYSE:T)") end if %> and EASTMAN KODAK <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EK)") else Response.Write("(NYSE: EK)") end if %> used stock mergers to acquire businesses unrelated to their core competencies, a practice Peter Lynch calls "diworsification." Moreover, takeover fever during the 1980s led many companies into ill-conceived, defensive acquisitions designed mainly to fill their balance sheets with debt so they'd be unattractive to suitors.

Loughran agreed that each era is different. Companies today, he said, are more focused on their core identities, meaning that today's mergers are often designed to enhance a company's competitive position and thus may make more sense. He worried, though, that target firms often are simply an industry's losers. For acquirers to buy them mainly because they're inexpensive may not be a great idea. Loughran also said that the human aspect of dealmaking has changed very little. Thus today's deals are just as prone to miscalculations as those in the recent past.

A PHILOSOPHICAL QUESTION

In any event, these studies offer much that individual investors can use. Yet they also raise one curious philosophical problem.

Ordinarily, we tend to think that America's equity markets work well because they allow companies to raise capital at the lowest possible cost. The public disclosure of material information required by the Securities and Exchange Commission (SEC) inspires confidence in the markets, which in turn makes them more liquid and thus more efficient. Yet, these recent academic studies reveal that companies actually tend to take advantage of the market's inefficiency (an overvalued stock price) when attempting to raise capital (new issues, stock merger).

In a sense, these papers imply that U.S. businesses, in general, periodically have access to capital at an unreasonably low cost. Inexpensive capital actually encourages managers to undertake actions that are detrimental to stockholders, both the existing ones and those who buy into an offering or gain a stake in a company by way of a stock swap. Indeed, the fact that all-cash tender offers wildly outperform stock mergers suggests that higher capital costs may actually lead managers to act more responsibly in pursuing growth opportunities.

In other words, were the stock market truly efficient, investors would likely come out better in the long-run. Until that magic day comes, however, investors can perhaps save themselves by looking long and hard at a company that issues new shares. Twenty years of data suggest they might do better by jumping ship.

--Louis Corrigan (RgeSeymour)

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