Decoding Rights issue – Is it sheer luck or skill to earn? Is it worth investing? – Zaid Writings

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There’s no predefined way to earn in the markets. There are multiple strategies to create alpha in the markets – factor-based investing, momentum investing, value investing, growth investing just to name a few.

Some people will tell you that he/she only invests as a fundamental investor who analyses the company deeply before investing. Some will say he/she earns through technical calls/analysis. Some will tell that he/she invests in a mix of fundamental & technical basis. The investing style needs to suit a person’s own risk-capacity & psychology as peaceful night sleep is way more important than thinking of ticker price every time.

Special situations investing is one of the ways where one can find a way to get some return from the markets. It includes various tactics such as Buybacks, Spin-offs, Rights issue etc. This post is all about rights issue.

When I first started understanding rights issue, few questions hit my brain such as – What happens when a company does rights issue? Can we earn through rights issue? Is there a sure-shot profit? Can we earn in futures/options market if a company does rights issue (arbitrage opportunity)?

Let’s understand the fundamentals of the rights issue. At the end of the blog, I have attached a link to the google sheets through which you can quickly analyze the rights issue.

Starting with the basic – What is a rights issue?

A rights issue is simply a potential share of a company. It is simply an option for the existing shareholders to buy the additional equity share of the company. It is upon the discretion of the shareholder to apply for the rights issue. If he/she doesn’t want to apply – ignore the rights issue.

Putting it in a different perspective, if a person needs money, will it directly go to the bank, strangers etc. to ask for money? Or will it knock the doors of his/her own/close people? Same goes for the corporate!

A generalized thought we all have is that rights issue always comes at a discount to the current market price (CMP). But a company can also issue rights at a premium. This is a blog (link) by @Kiran D which shows that Arrow Greentech Ltd (previously known as Arrow Coated Products (ACP) issued rights at a premium in 2012.

This let me think, is this a normal scenario? Thus, to prove whether company issues rights at a discount or premium, I did one exercise of checking the difference between the rights issue price & the current market price before few weeks of the ex-date of rights issue since Jan 2010 till Mar 2020.
Note: To calculate premium or discount, I took unadjusted price. I did this because if let’s say a rights issue is done in 2011, the rights price will quote the price of that period. But if the company gave a bonus, split etc. the adjusted share price will show the wrong picture.

Zerodha shows the historical unadjusted price (see the historical share price of any company e.g. Adani Enterprise on the website & you’ll easily understand the process).

There are in all 142 rights issues between Jan 2010 to Mar 2020. Out of which 137 rights issues (about 96%) were at a discount (Rights price < CMP). Indeed, there are exceptions. 5 out of 142 rights issues were at a premium (Rights price > CMP).

One can debate here that – “Why would I subscribe to the rights if it is at a premium?” “Isn’t it better to buy it at CMP?” I’ll agree to some extent but, think of it like this – “Don’t you think if the company is issuing rights at a steep discount to CMP, it shows how desperately the company needs money?” “Don’t you think, it is the power of the company to get money at a higher price than the current value?” Although there can be many other reasons, these are just some thoughts which justifies the issue.

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Does the rights issue dilute earnings per share (EPS)?

This is another generalized statement that hits our mind whenever we hear something on the rights issue. I did one exercise to understand the reality behind the dilution of the EPS.

Let’s say the company issued rights on June 2011. Now, as per the generalized thought when the company declare the next result (Annual result/FY12), EPS should be diluted. I calculated the difference between FY11 EPS & FY12 EPS to let the data speak. I did the same exercise for the companies which issued rights from April 2011 to Dec 2019.

Let’s look at the data –
Note: I took the EPS data from the screener. I removed the companies which have no data. FY20 data was not yet released when I write this. So, for companies which issued the rights between April 2019 to Dec 2019, I have taken the TTM (Trailing twelve months) EPS.

There are in all 100 companies. EPS rose for 56 companies (56%) out of the total & the remaining companies EPS declined.

EPS is the function of earnings (Net profit) & outstanding shares. A company gets money after issuing rights which eventually increases the outstanding shares. But this is just one part of the equation. EPS also depends on the usage of that money. If the company allocates the money which increases the net profit, then don’t you think the EPS should rise.

Does the Rights issue dilute equity?

Let me clarify the difference between the dilution of Equity & EPS. Dilution of EPS is the decreased per-share earnings that shareholder gets. Dilution of equity is the decreased ownership in the company.

EPS will not dilute if the company earns better with the new money. But equity (ownership) has no relation with earnings. Equity will dilute if you don’t participate in the new issue even if the company earns better with the new money.

What is equity dilution?

Equity dilution is the decreased ownership after the issue of new shares.

Let’s say there’s a company named XYZ. Rahul & Karan owns 50%-50% of the company. Now, the company requires money. Rahul & Karan decides to issue new shares to get some money. The condition is – they (Rahul & Karan) will not give any money. Aman (a new businessman/investor) fully subscribes to the new shares of the company.

Ownership details –

After the rights issue, Rahul & Karan’s ownership in the company declined to 33% from 50%. In other words, it means that from now on, Rahul & Karan is entitled to get 33% of the profit/loss as compared to 50%.

Thus, the new issue will only dilute equity if the existing shareholders don’t apply for the issue.

How to earn through rights issue?

Let’s say Company Y has 10,000 outstanding shares. Its current market price (CMP) is ₹100. It decides to raise money to invest in the business & to pay off some debt. It announces that the shareholders have the right to buy say 1 additional share for every 2 shares held at a price of ₹60. It means a 40% discount to the current market price. The record date is 20th June 2020 (Ex-date will be 19th June 2020).

How to participate in this opportunity?

First thing, buy the share before 2 days of the record date (watch out for holidays). Let’s say you bought 100 shares at ₹105. I have assumed a higher price because I have seen many rights issues where after the announcement, the share price rises may be because of the buyers who want to participate in the issue.
Note – Investment value is the multiplication of shares you bought/already had and the average price.

Secondly, sell the shares on the ex-date (one day before the record date) or thereafter. You will still be eligible to apply for the rights issue. On the ex-date, the share price should fall.

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How much the share price will fall on the ex-date?

I learned this thing from the blog (link) of Abhinav Mansinghka and Niren Parekh. The theoretical price on ex-date will be determined as per the formula by the exchange –

In the above example, the price on the ex-date must fall to [(2 * ₹100) + (1 * ₹60)] / 3 which will be ₹87. It means that on ex-date the share price must fall to ₹87.

One can judge after looking at the formula that the quantum of share price fall is mostly dependent on the ratio & the discount to CMP of the rights issue.

Let me give you an example – Reliance rights issue (May 2020) came at a discount of around 12%-14% to the CMP of that time. Its rights issue ratio was 1:15 (means 1 right for every 15 shares held).

Likewise, 5Paisa Capital rights issue (May 2019) came at a discount of around 70%-76% to the CMP of that time. Its rights issue ratio was 1:1 (means 1 right for every 1 share held).

Hence, the steeper the discount & the offering, the steeper the share price fall on the ex-date.

Now, the company announces a period during which you can make your application (you can find the announcement in the corporate announcement section on the exchange website). Ideally, you should apply for extra rights. In our case, we bought 100 shares & the ratio is 1:2 which means that you may get 50 rights. But, if you want more rights, you can apply for it say in our case you apply for 150 rights.

Now, as per pro-rata basis, you’ll get your rights. In case when 100% of shareholders apply for the rights, you’ll not get anything extra. In case when less than 100% apply for the rights, you may get the extra rights. In some case, when there is an oversubscription of the rights issue, you may not even get the rights.

I had conversed with many investors who applied for the Reliance rights issue (May 2020). Due to the oversubscription of nearly 1.6 times, many of them didn’t even get a single right. Now, if you are investing in the company, just to play the rights issue, this kind of situation will cause you a loss if you sold the shares on or after the ex-date. Imagine you bought the shares at ₹150 after the announcement & the share price fell to ₹100 on the ex-date & you sold the shares at ₹50 per share loss. And you don’t even get the rights! Imagine the level of frustration you’ll face.

Let’s do the math taking different scenarios of getting rights in our example – while noting that after getting the rights (additional shares), you sell them at say ₹95.
Note: Invested value = Number of shares/rights * Average/rights price
Net profit/Loss = Net amount of Profit/Loss by selling rights shares and loss of selling the shares on ex-date
Return on investment = Net profit/Loss * Total invested value (Invested value in shares + rights)

One can see the advantage of getting more rights!

Assume that now we can sell the rights shares at ₹105.

The higher the selling price & the allotment of rights, the higher the profit.

Note that this profit is just in a time frame of 2-4 months.

The time-frame of rights issue –

Summarizing the rights issue (How much is the “luck” component?)-

Key points which we need to remember:

You can see that you need to be very lucky to earn in a rights issue. If you are unlucky, then you’ll not lose much assuming that you get the rights and was unable to sell it at a higher price. If you don’t even get the rights, then you’ll be in trouble.

Can we earn an arbitrage via futures or options?

Now we know that it’s a bit challenging task to earn in a rights issue. But we also know that rights issue leads to a fall in the share price (outstanding shares increases). Can’t we short the futures or buy a put option to benefit from the fall? Short answer – No.

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Long answer – There’s an adjustment done by the exchange which leads to sudden correction of the futures & the options prices. Let’s understand it via an example.

Assume that Company X announces a rights issue (1:1 ratio). CMP is ₹100 & the rights price is ₹65.

Step 1 –
Note: Total holding of shares is also known as entitlement

Step 2 –

What is the benefit per right in this issue? The difference between (CMP & the rights price)*Right i.e. [(₹100 – ₹65) * 1 = ₹35], isn’t it? But this is per right benefit. We need to quantify per share benefit.

Note- Just to avoid confusion, assuming if the rights ratio is 2:5 (2 right for every 5 shares), then the benefit per right would be ([₹100 – ₹65] * 2 ) = ₹70

Step 3 –

Per share benefit (It shows that the quantum of benefit per share) = Benefit per right / Total holding = ₹35 / 2 = ₹17.5

What is the arbitrage here? By doing nothing, we are earning ₹17.5 per share.

Step 4 –

There’s something known as an adjustment factor. It is a a figure introduced to balance the effect of arbitrage.It is calculated as the difference between (per share benefit & CMP)  CMP.

In our case, the adjustment factor will be (₹100 – ₹17.5) / ₹100 = ₹0.825

It means that ₹1 thing should ideally worth ₹0.825 to offset the effect of arbitrage.

Effect on futures –
Note: Before adjustment’s future price ₹105 & market lot of 50 are assumptions.

We just multiply the futures price by 0.825 (105  0.825), we get ₹87. We divide the market lot by 0.825 (50  0.825), we get 61 market lot.

If you are already short on Company X’s future, the future price correction will offset the arbitrage. If you want to short after the adjustment, you have to buy more (lot) which offsets the arbitrage

Effect on options
Note: All the strike prices (before adjustment) are assumptions.

Just multiply the adjustment factor (0.825) with the strike prices. There will be a fall in the strike prices of the options.

Case study of futures adjustment – Reliance Industries

This correction is similar to a share price fall when a company gives bonus shares. The fall in the share price is not a gain/loss. It is just the adjustment.

Thus, there’s no free money in the rights issue.

Closing statements –

I am in a very nascent stage of my career. While I am writing this, I invested a small portion of my portfolio’s money in the Mahindra & Mahindra Financial Services Ltd rights issue (July 2020). This is my first ever rights issue investment. I want to see how things play out. I will share my experience with the rights issue soon.

You can read real-life examples of rights issue investment shared by renowned investment gurus which helped me a lot – (just click on the link)

-> Kiran D’sTales of Two Rights issues & The curious case of Fame India (Rights issue)

-> Neeraj Marathe’sRights Issues – get it right! & Jyoti Structures Ltd – Interesting rights issue

Google Sheet to analyse rights issue – Link

(This is my analysis of M&M Financial Services rights issue. You can make a copy of the sheet & can adjust the numbers)

Happy investing! 😊

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Zaid Munshi

Zaid Munshi

Zaid started his journey in the Indian market in April 2018. He is always keen to understand the business and check whether the business is worth investing or not.
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