Swedroe: Equity Offerings & Tail Risk

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.

Findings

Following is a summary of Boehme, Fotak and May’s findings:

• 18.5% of firm-years in the sample contain a price crash, with an average fall of 23%.
• The issuance of seasoned equity is associated with abnormally high future stock price crash risk.
• Among firms that complete an SEO, nearly one in four (24.2%) experience a stock price crash in the following year. In contrast, among firms that have not recently issued seasoned equity, the proportion experiencing a crash is only 18.1%. The difference (6.1 percentage points) is highly statistically significant—as well as being economically significant—and corresponds to a 34% rise in the probability of a price crash.
• The association between SEOs and crash risk is stronger among offerings that involve the sale of secondary shares (existing shares sold by insiders and large institutional shareholders). The sale of secondary shares by insiders and large institutional shareholders in an SEO may therefore constitute a stronger indicator of the potential for bad-news hoarding and, thus, a stronger signal about future crash risk.
• Even after controlling for known predictors of crash risk (including firm size, leverage, profitability, market-to-book ratio, past stock return performance, return volatility, return skewness, trading volume, abnormal accruals, tax avoidance and the stability of institutional ownership), the results strongly suggest that the issuance of seasoned equity embodies significant predictive information on the risk of a future crash.
• Among firms in which SEOs include secondary shares, 27% experienced a price crash in the fiscal year after the offering, while 22.3% of firms that complete purely primary offerings crash in the fiscal year following the offering.
• Recent seasoned equity issuers are far less likely to experience sudden positive price jumps relative to firms that have not recently issued equity, providing evidence against the hoarding of good news. In fact, 28.6% of firms without an SEO in year “T” experience a jump in year T+1. In contrast, only 18.2% of firms with an SEO in year “T” have a price jump in year T+1. The difference between these two estimates (10.4 percentage points) is highly significant, indicating that jumps occur with unusually low frequency after SEOs.
• Net selling by CEOs and CFOs is abnormally high in years succeeded by crashes relative to years not succeeded by crashes, and is especially high among seasoned equity issuers that subsequently crash. The differences were highly statistically significant. This is consistent with crashes, especially those that occur after SEOs, resulting from bad-news hoarding.

Summary

Tail risk is important to investors, with the research showing that idiosyncratic tail risk is priced in the cross section of equity returns. The evidence presented in this study contributes to our understanding of the causes of tail risk.

Boehme, Fotak and May concluded: “The findings of elevated crash risk and diminished jump risk, when taken together, are consistent with a heightened propensity for firms to hoard bad news but not good news when issuing equity…. Our research shines the spotlight on an observable corporate event that embodies useful information regarding future tail risk in equity returns.”

For investors who purchase individual stocks, the findings here provide a strong warning about the heightened tail risks of owning stocks that have recently undergone an SEO, especially if it includes the sale of secondary shares. Later this week, we’ll take on another study that provides evidence to support Boehme, Fotak and May’s findings.

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