“There are times… when all the world’s asleep… The questions run too deep… For such a simple man.”
— from “The Logical Song,” as performed by Supertramp
Imagine that you and your three siblings purchase a rental house for $1 million. Each of you owns a 25 percent share in the property after an investment of $250,000. Shortly afterwards you are notified that significant property repairs are required. The repairs total $250,000, or another $62,500 per sibling.
So how should you handle these maintenance expenses? Assuming that you and your siblings are all debt averse, your two options are to attract another investor or ask each sibling to pay his share.
The benefits of bringing in a new partner are obvious. They can pay the full $250,000 improvement as their buy-in and you don’t have to pay anything. But a new investor is going to want equity for his money. By choosing this option, you don’t have to come up with any cash, but you also watch your stake in the house get reduced from 25 percent ownership to 20 percent.
This is essentially what happens when companies issue additional shares of stock — every current stockholder’s ownership interest gets diluted. This is not ideal from a current shareholder’s perspective.
What about the option where all current owners are asked to kick in more money? That doesn’t sound too appealing, right? This happens occasionally in the stock market and is known as a rights offering. Existing shareholders are given the right, but not the obligation, to inject more capital in the company. But here’s the kicker: if you don’t pony up extra cash, your ownership percentage declines. Because being asked as an investor to cough up more dough just to maintain your current share of a company is anathema to many investors, stocks undergoing rights offerings can sometimes be a strategic place to look for value.
Knowing how lay shareholders sometimes respond to rights offerings, entrepreneurial management teams often initiate them as a way to increase their share in the company on the cheap while everyone else is rushing for the exits. The company’s future may actually be bright, but management often waits until the rights offering ends (and after they’ve acquired as much stock as they want) to share that things may be looking up! Then their tone might become more positive about the company’s future.
How can the average investor know these things? Spotting value takes a practiced eye. But here’s a heads up: just because a company in which you own stock issues a rights offering doesn’t always mean it’s in trouble. It could mean just the opposite, and thus, holding on to your shares or even buying more can sometimes be an astute decision.
Margaret R. McDowell, ChFC®, AIF®, author of the syndicated economic column “Arbor Outlook,” is the founder of Arbor Wealth Management, LLC, (850.608.6121 – www.arborwealth.net), a “fee-only” registered investment advisory firm located near Sandestin.