In a world with closed credit markets and stressed balance sheets, big capital raisings, some of which reached the regulated limit of 15 per cent of company stock, were the most viable way to restore weak company finances. Even at the expense of share dilution. Corporate survival – not preservation of earnings per share (EPS) – was critical, says Martin Littler, head of core Australian equities with Colonial First State Global Asset Management (CFS GAM). “If you didn’t raise capital, and the business went under, it would be a disaster,” he says. Littler, a veteran Australian equities fund manager, says the boards of big companies debated whether to raise capital and dilute earnings, or ride out the crisis, confident their debts were under control. Highly geared companies with looming refinancing deadlines, such as real estate investment trusts (REITs) and some financial businesses, had no choice.
“They were so close to death. All they’ve done is stave off bankruptcy while they wait for the world to get back on its feet,” Littler says. Companies such as Boart Longyear, Elders and Pacific Brands ran very dilutive raisings, Littler says, while REITs raised equity off already low net tangible asset values, ranking them among the most diluted stocks. In these cases, new capital was used to plug holes in balance sheets rather than committed to earnings-accretive investments or acquisitions, ensuring EPS dilution for the foreseeable future. But for some investors, the big discounts on offer easily compensated for the dilution. “Beauty is always in the eye of the beholder,” Littler observes. Because the raisings were primarily conducted by the larger companies in the index, the discounts provided good opportunities to buy into them, Fidelity’s Taylor says, pointing to the big four banks.
“If they were raising at attractive prices and it repaired their balance sheets, it proved the best opportunity to buy into the banks.” Entitlement offers, which reserve equity for existing shareholders, provided a means of mitigating dilution. “As an existing shareholder, you only get diluted if you get under your previous position,” Taylor points out. While capital raisings brought some businesses back from the brink, other companies issued equity as a precaution against further market fallout or to assure investors they had a good chance of surviving the recession. Since most of this new capital was not put towards balance sheets, these companies are capable of making acquisitions or, if they are very confident, conducting share buy-backs to reduce shareholder bases and drive EPS higher. The big four banks and Boral are examples of companies flush with capital, Littler says. “The banks have all raised capital.
Now we’ve come out the other side, and the bad debts, unemployment and housing market are not as bad as we thought. Time will tell whether they buy-back or raise equity for more acquisitions.” Taylor says companies are feeling more confident and are considering ways to strengthen their businesses. “People are already talking about banks having too much capital. But the next phase will be more merger and acquisition-type activity.” Now that big companies have finished raising equity for recapitalisation, and the prospects of further issuances at discounted prices are slim, investor confidence has improved and managers are no longer keeping so much money on the sideline, Taylor says. But he predicts that mid and small cap companies will soon issue more equity now that the run of offers from big companies has finished. For quantitative managers, capital raisings are typically a negative signal because they dilute EPS.
But the severity of the crisis meant the recent series of raisings were received positively by the market, Don Hamson, managing director of Plato Investment Management, says. “In this do-or-die situation, most stocks have rallied after raising equity because there is relief they haven’t gone bankrupt.” However, despite the steep discounts, it will be some time before EPS nears undiluted levels. “Even if total earnings get back to the same level, it will be very hard for stocks to trade back at the levels that they were on,” Hamson says. Japan ’s dilution dilemma Ben Inker of GMO says the dilution of company earnings is a fundamental cause of the stagnation continuing to plague the Japanese equity market. In 1989, the Nikkei 225 nudged 40,000 points, generating a price/earnings ratio (P/E) of 62. But in the next 18 years, it fell 82 per cent to about 7000 points, and coughed up a P/E of just 8.6. “Short of revolution, Japan is the worst thing to have happened…How do you go 20 years without having any increase in valuation?” says Inker, GMO’s Boston-based chief investment officer.
The shrinking Japanese workforce is not the cause of this woeful performance, he says. Since 1989, the nation’s annual per capita GDP has been 1.75 per cent, compared to 1.5 per cent from the US. Theoretically, the EPS of Japanese equities should have more than doubled since 1989, but now stands at roughly the same level. Inker says Japan’s lost years have been caused by rampant share issuance from companies in an economy growing slowly. As EPS was spread among an increasing number of shareholders, it fell far short of its potential, making dilution an “unmitigated disaster” for the Japanese market. Dilution is also a looming problem in the US market. At the close of 2008, its quarterly net share issuance rate spiked to 5.7 per cent, a level higher than any recorded since the 1950s.
In a diluted market, companies with capital shortfalls are more attractive because any equity they raise will most likely be put to work in acquisitions or operations that will create growth and drive EPS higher, rather than shoring up balance sheets. “The share issuance we’re really interested in is the issuance needed to repair the balance sheets of companies,” Inker says. “If you have raised relatively expensive equity to pay off relatively cheap debt, you have a problem. You wake up and find yourself over-levered.” Dilution with no EPS growth indicates that a company’s balance sheet is “unsustainably over-levered”. It seems likely that Australian equity managers will soon be diagnosing which capital-hungry businesses in their portfolios display this symptom.