Why Investors Should be Wary of Recent Extensive Equity Issuance
I believe we are now at an important stage to remind everyone of a basic academic theory; The Equity Market Timing Theory of Capital Structure. Firstly, I will explain the basic theory and then indicate why this is immediately important when analysing investment opportunities.
First proposed by (Baker & Wurgler, 2002) the theory states that firms’ capital structure (i.e. level of debt to equity financing) is dependent on the market value of the firms equity (MV) in comparison to the book value (BV) and previous market values. If the current MV is overpriced relative to the BV, giving a book to market ratio (B/M) below 1, then the managers of the firm would be incentivised to issue equity. However, if the B/M ratio is above 1 indicating the current MV is too low they would be incentivised to buyback equity cheaply thus increasing the proportion of debt in the capital structure. We assume that there is asymmetric information, whereby managers hold more information than investors.
We can think of this with the example of a car. As the owner and “manager” of the car we are endowed with information as to the true value of the car based on mileage, engine usage, paint work, original parts etc. Now imagine we want to sell the vehicle and go to a dealer to get a price. If we know the true value is £2,000 and the dealer offers us the “market price” of £2,500, we would be incentivised to sell as we are making a premium over the true value of £2,000. However, if the dealer now offered us £1,500 we would not sell the car as we would be selling the car below its worth, we may even buy another identical car at that price (like the share buyback) as we know it is undervalued.
This is the same case with a firm’s equity, they would only be incentivised to issue more equity if they can receive the highest value for the sale of each share, i.e. when it is overvalued. They can then use this extra cash to invest in new projects or hold onto to meet cash flow requirements.
In times of crisis, cash and liquidity are king. Firm’s may have strong products, R&D pipelines and a broad customer base, however if they are unable to meet working capital requirements and cover short term liabilities they face the harsh reality of bankruptcy.
Index and Share Prices
Typically share prices would plummet to reflect the poor economic climate, which was initially the case in Mar-20 where global indexes and share prices fell off a cliff. However, prices have since gone on to return to near record highs, as can be seen by the S&P500 Index shown in figure 1 (Yahoo Finance, 2020). There are many factors driving this including government fiscal stimulus packages, loosening of monetary policy and an optimistic market sentiment that has priced in virtually a full recovery in 2021.
How much equity issuance?
In May-20 and Jun-20 share prices have returned to near pre-pandemic levels. Net equity capital issuance in May-20 for UK-residents was at £5.2bn. This was compared to £2.8bn in April and the previous six-month average of £0.5bn, mostly from private non-financial corporations, as can be seen on figure 2 below (Bank of England, 2020).
As we can see there have been vast amounts of equity issuances in recent months, well above the long-run average. There are many potential reasons behind this, but one factor is that managers have far better visibility of the lockdowns harm to finances and liquidity constraints than the average investor and many will be attempting to take advantage of their current high MV, building up a protective buffer.
The key takeaway is that although releasing equity may be a sign of growth as firms look to invest in high return projects, there may be some alternative reasons behind this and investors should be careful when selecting investment opportunities that they do not get stuck with a failing companies’ stock that are simply attempting to improve liquidity at the optimal time.
Baker, M. & Wurgler, J., 2002. Market Timing and Captial Structure. The Journal of Finance, 57(1), pp. 1-32.
Bank of England, 2020. Capital Issuance - May 2020. [Online] Available at: https://www.bankofengland.co.uk/statistics/capital-issuance/2020/may-2020 [Accessed 5 July 2020].
Yahoo Finance, 2020. S&P500. [Online] Available at: https://uk.finance.yahoo.com/chart/%5EGSPC [Accessed 5 July 2020].