Swedroe: Issuing Securities Hurts Returns

July 31, 2017

IPOs involve a great deal of uncertainty, which makes them riskier. As a result, investors should demand higher expected returns as compensation for that greater risk.

However, a large body of evidence demonstrates that, unless you are sufficiently well-connected (specifically, to a broker-dealer who is part of the issuing syndicate) to receive an allocation at the IPO price, IPOs have underperformed the overall market.

The poor risk-adjusted performance of IPOs raises the related question of how well the stocks of frequent issuers (both of stocks and bonds) perform.

Recent Research

Rongbing Huang and Jay Ritter contribute to the literature on this subject with their March 2017 study, “The Puzzle of Frequent and Large Issues of Debt and Equity.”

Using U.S. firms’ equity and debt issuance information for the prior three fiscal years from 1974 through 2014, Huang and Ritter documented the importance of the number of issues, issue size, how recently issues occurred, type of security issued and number of types of securities issued in explaining stock returns in the subsequent year.

Following is a summary of their key findings:


  • An economically important proportion of firms engage in substantial external financing activity during the prior three years. More than 10% of all firm-years are preceded by at least three issues of debt or equity, with a firm classified as an issuer in a year if the equity or debt issue exceeds 5% of assets and 3% of market cap at the beginning of the year. Almost 6% of all firm-years are preceded by at least three large issues, with a large issue defined as more than 10% of assets and 3% of market cap.
  • For firms with zero, one, two and three equity issues in the prior three years, the mean buy-and-hold returns in the following year are 20.1%, 13.8%, 7.1% and -8.3%, respectively. That’s a spread of 28.4 percentage points between nonissuers and three-time issuers of equity.
  • The mean market-adjusted, three-year buy-and-hold return for three-time equity issuers is -37.0%.
  • For firms with zero, one, two and three debt issues in the prior three years, the mean raw returns in the following year are 19.7%, 17.7%, 12.1% and 8.1%, respectively.
  • Firms with no debt or equity issues over the previous three years have an average raw return of 21.1% in the following year. In contrast, firms with six issues have a negative mean raw return of -9.2% in the subsequent year. The spread in the mean subsequent one-year raw returns between firms with zero and six issues is 30.3 percentage points.
  • The average return for a value-weighted (VW) portfolio of firms with at least three issues in the prior three years is -0.43% per month in the subsequent year, and for firms with at least three large issues, -0.64% per month.
  • More recent issues are followed by lower average stock returns. A VW portfolio of firms that made two equity issues in the previous two fiscal years, with no issues in the fiscal year three years prior, had a five-factor (beta, size, value, investment and profitability) alpha of -0.52% per month in the subsequent year. A VW portfolio of firms that didn’t issue equity in the most recent year, but did twice in the two years prior to that, had a five-factor alpha of -0.28% per month.
  • The five-factor (beta, size, value, investment and profitability) model and the q-factor (beta, size, investment and profitability) model generally improve the description of the portfolio returns. After controlling for the factors, firms with one, two, three or at least four issues in the prior three years underperform those with no issues by 0.11%, 0.37%, 0.58% and 1.15% per month, respectively, in the subsequent year.
  • Equity issues on average are followed by lower raw returns than debt issues. Firms with one, two and three debt issues in the prior three years underperform nonissuers in the subsequent year by 0.09%, 0.30% and 0.62% per month, respectively, while firms with one, two and three equity issues underperform nonissuers by 0.30%, 0.64% and 1.25% per month, respectively. This suggests that firms issue equity rather than debt when the cost of equity is low—they are successful market timers.
  • Controlling for the Fama-French investment and profitability factors, frequent issuers of debt and equity had negative abnormal returns, with abnormal returns being even lower for firms conducting large issues.
  • Equity issuers tend to have low profitability and heavy investment, characteristics that are associated with low average returns.
  • There was strong evidence that more frequent and larger issues, especially equity issues, are associated with lower stock returns around earnings announcements made in the subsequent year. In other words, earnings fail to meet expectations.
  • Equity issuers are less profitable than debt issuers. Intuitively, profitable firms find it easier to borrow than money-losing firms.
  • The underperformance of frequent and large issuers did not weaken over time.


‘Abnormal Negative Returns’

Huang and Ritter note their evidence is consistent with the market-timing theory that firms issue a security when the expected return on that security is low, possibly due to market mispricing.

And it’s also consistent with the theory behind the q-model (proposed by Kewei Hou, Chen Xue and Lu Zhang), as subsequent returns following heavy investment should be lower, because required returns are lower.

The authors added that “frequent and large issuers have negative abnormal returns after controlling for these characteristics. Furthermore, the abnormal returns are lower the more recent the external financing has been. These findings are consistent with successful market timing but not with the q-theory.”

The evidence presented in Huang and Ritter’s study makes the case that screening for large issuers is a way to add smart beta to a fund’s construction rules.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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