Swedroe: Equity Offerings & Tail Risk

April 27, 2016

It’s logical to believe that corporate managers have a preference for issuing equity at times they perceive their firm’s stock price is overvalued or high relative to some benchmark (such as price-to-earnings ratio or book-to-market ratio). The academic research on the subject supports this hypothesis—seasoned equity offerings (SEOs) do tend to be preceded by unusually high stock returns.

The academic research also shows there are incentives that can lead corporate managers to have a tendency to hoard bad news (for example, concerns about current-period performance-based compensation, prospects for promotion, future employment, post-retirement benefits such as directorships, the potential for termination, and the hope that subsequent positive events will allow them to “bury” the negative news).

They withhold and accumulate bad news for extended periods of time, keeping stock prices temporarily higher (think WorldCom and Enron), though bad news cannot be postponed indefinitely. When the accumulated bad news eventually is revealed, the stock price crashes.

Equity Offerings And Bad News

Rodney Boehme, Veljko Fotak and Anthony May, authors of the April 2016 study “Crash Risk and Seasoned Equity Offerings,” believed that the confluence of these two concepts implies a potential for a strong association between equity issues and the hoarding of bad news.

They note that “the decision to proceed with an equity offering, in and of itself, can exacerbate management’s incentives for bad news hoarding in order to avoid significant price declines prior to offering completion.”

This led the authors to hypothesize that “recent equity issuers should be especially prone to sudden crashes—when accumulated bad news eventually reaches a threshold level that managers can no longer sustain, it tends to come out all at once or very quickly, resulting in a very sudden and extreme drop in the stock price, which is empirically identified as an extreme left-tail outlier in the distribution of weekly or daily firm-specific returns.”

The study, which covers the period 1987 through 2011, contributes to the literature by examining whether firm-specific crashes are more likely to occur after SEOs. Approximately 40% of equity offerings during the period studied included secondary shares.

Boehme, Fotak and May estimated firm-specific (idiosyncratic) weekly returns for each firm-year in the sample using a five-factor model. Their model included the three Fama-French factors (beta, size and value), momentum and an industry factor. They defined a stock as having experienced a price crash in a given week if the firm-specific log-return came in at 3.09 or more standard deviations below a firm’s mean weekly firm-specific log-return during that fiscal year. The standard deviations cutoff of 3.09 was chosen to generate a frequency of 0.1% in the normal distribution.


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