A Coming Flood of Equity Issuance, aka The Dilution Solution

Since mid-March, I have been pegging the peak of the rally at 860-920 on the S&P 500. While the high close was about as close to 920 as one can get (919.53), the market briefly traded above my "line in the sand" yesterday and even again in the pre-market this morning. It could go higher, but I continue to think that this is a proper rally from extremely oversold conditions but that the headwinds will keep blowing for many quarters to come despite the current optimism.

With the benefit of hindsight, it is now much easier to understand why stocks went so low and rallied back so sharply. Scenarios of equity extinction gained a lot of traction early in the year. In a very cold and calculating manner, one can envision scenarios where companies face short-term gaps in their funding that can't get met due to the capital markets being "frozen", and they get "Lehmanized". Very simply, if a company has a short-term obligation and can't either borrow the money by extending the loan or refinancing it or raise cash through asset sales, it is technically bankrupt. The only alternative is to sell stock. Hence, we had lots of stocks heading well below book value or even tangible book value. This is exactly what was going on with General Electric (GE), which I called a "value pit" in late December.

Things got so insane that I had to defend GE (see the comments in that same article) on March 4th:

I am following up 10 weeks after I published my views on GE. While I continue to believe that GE's equity may ultimately be wiped out, I believe that today's price of 6.40 or so is most likely a price that better reflects the risk/reward opportunity than previously. If I were short the stock, I would consider covering here for now. If I were long the stock, I would avoid selling it now.

The market failed to realize that if the credit markets stayed frozen forever the conclusion was correct, but they wouldn't stay frozen forever. While spreads remain sky-high and availability relatively low, credit is flowing again. We see now that banks are beginning to issue equity, with WFC doing a modest $6 billion deal today.

I believe that the rest of the year will see equity issuance pick up. Many companies outside of Financials need to address their capital structures. The cost of issuing debt remains high, and the risks of waiting for improvement would seem to be too great. It's time for companies to bite the bullet and repair their balance sheets, raising enough equity to cover debt maturities for the next several years. Many companies have been repurchasing their debt at steeply discounted prices, which further supports the potentially accretive nature of share issuance despite the low PEs (are they really so low?).

The need to raise equity capital is even greater for companies with high amounts of intangibles on the balance sheet. These companies will be running impairment tests later in the year and could see their equity written down. Impairments could potentially trigger debt covenant violations. I believe a great example of this is Vulcan Materials (VMC). I have recommended shorting the stock to my clients, as they have a short-term funding gap (0.7X current ratio), a ton of intangibles (thanks to buying Florida Rock at the top), debt covenants on their substantial debt and maturities in the intermediate term. They should eliminate their dividend immediately and sell $1 billion of stock (20% of the market cap). This is just one example, but go back and review my list of companies with high intangibles. These stocks, like the market in general, have rallied from their lows. It's time to recapitalize. If they don't, they could be subject to the whims of the market later this year.

Disclosure: No position in any stock mentioned.

Comments

[altaman:]

This is the same solution used by your local sewer plant.

May 08 07:39 PM

[jeandit75:]

Excuse me "WHO KILLED WIM DUISENBERG???" but there is no place for comments and people like you on this site.

May 09 03:10 AM

[justdoingmyjob:]

Wim Duisenberg died from a heart-attack brought on by chain-smoking. Hanging anyone in the U.S. is a capital offense, a crime that, itself, carries a capital punishment in many states. Any restricted sites should be password-protected, or typically can be accessed by anyone on the WWW. First amendment of the US constitution basically guarantees freedom of speech for anyone, regardless of religion, ethnicity or any other factor. Any other questions or comments on the matter?

May 09 09:51 AM

[ArtfulDodger:]

Good article and excellent points, AB.

As always, you're at the heart of what's happening underneath the hype. Indeed, the deleveraging must continue.

And this article makes me stand by my view of what to buy and what to sell during this type of economic atmosphere: buy cash and free cash flow, and sell debt and negative cash flow.

I feel the same way about which nations to invest in: buy those with minimal debt and plenty of cash; sell those with lots of debt and large deficits.

Any suggestion on these points, AB, I would appreciate.

Thanks again for your work.

May 09 10:04 AM

[slipperyrazor:]

WIM, every now and then people such as you pop up, out of your hole.All of you have the same ol' agenda. At least try to be more creative! How about the thought that Goldman controls the government! That should keep you busy, doing something totally useless, such as your last post was.

May 09 10:45 AM

[GDK:]

Any thoughts on what the market reaction on Monday will be when the Obama folks "adjust" the national projected deficit for this year to TWO TRILLION DOLLARS? How soon will the Treasury issue debt which is not successful and the Fed must sop it up?

I'm not a currency trader, but what ArtfulDodger said sounds like what I believe. I would think natural resource rich countries like Australia,Canada ad Brazil provide a better place than the dollar.

May 09 10:48 AM

[Ranger:]

Nice try to cover for your faulty market prediction. A person could do exactly the opposite of what you suggest and do all right in the market. You're another Cramer...nothing more. Maybe that market wizard Henry Blogett will let you on his show.

May 09 10:52 AM

[Prudent Man...:]

Why would anyone buy a stock in a company, especially a bank, that is kept alive by government intervention?

Interesting that the companies begging for equity are still managed by the incompetents who virtually bankrupted them.

I can hear the Goldman Sachs' millionaire peddlers calling their institutional investors and telling them what a great financial stock they have for them while they are shorting it. So much for fiduciary responsibility. Forty years ago they would have been put out of business and those were the days you could believe a financial statement.

If anyone wants to pay back the TARP I will believe them when they put the money in an independent escrow account. Money talks and b.s. walks!

May 09 11:33 AM

[Boom_Bust:]

The markets volume screams manipulation but even without manipulation markets have the tendency into getting trapped in these boom-bust cycles no matter how irrational they often seem. As the article says dilution is inevitable and the optimistic retail investors are in for yet another disappointment. Hopefully not the final one.

May 09 12:27 PM

[notsosmart:]

nobody has to buy & sell anything.yes its all ponzi/casino but you dont have to be in it.i dont get the whining & complaining.go & learn a trade & make a living that way. oh,you would rather trade cause your lazy.wake up.you have to play by their rules.like it or not.i dont think its the jews.its the etruscans or maybe the bicycle riders.LOL

May 09 12:39 PM

[Alan Brochs...:]

I am almost embarassed to admit that as much as I embrace globalism and the changing dynamics of international trade and capital, I am woefully focused on domestic investing. If I trusted Chinese accounting (my problem, not an accusation necessarily), I would think that would generally be a good place to focus too. I think that unlike most times in the past, the emerging vs developed markets question is dwarfed by the one you ask. Ironically, it is many of the developing countries that have the better balance sheets. Stick a gun to my head, and I will say go long the BRICs etc. Uninformed gut view...




On May 09 10:04 AM ArtfulDodger wrote:

> Good article and excellent points, AB.
>
> As always, you're at the heart of what's happening underneath the
> hype. Indeed, the deleveraging must continue.
>
> And this article makes me stand by my view of what to buy and what
> to sell during this type of economic atmosphere: buy cash and free
> cash flow, and sell debt and negative cash flow.
>
> I feel the same way about which nations to invest in: buy those with
> minimal debt and plenty of cash; sell those with lots of debt and
> large deficits.
>
> Any suggestion on these points, AB, I would appreciate.
>
> Thanks again for your work.

May 09 01:35 PM

[Alan Brochs...:]

Hey, is that an insult or a compliment when you call me "another Cramer"? I am more transparent than he is, but he is more entertaining and probably smarter too. Certainly more successful! His problem is that he overextends himself and then starts saying things just to fill time and to entertain. Unlike him, if I don't know (see my reply above), I say "I don't know".

As far as doing the opposite of what I suggest and making money, I find that accusation to be a little extreme. I actually have a published record (long only, no leverage) that has destroyed the market (see investbymodel.com). What goes into that body of work is pretty much what I share on Seeking Alpha, whether it is themes or individual stocks. I don't always get it right (who does?), but I think I get it right enough to pursue this full-time. As far as my call that you think was faulty, I think you are harsh. I publish the day the rally starts about how we could be on the verge of a huge rally, update it a few days later after it has begun and lay out what I THINK will be the top and find out that I may have been too conservative. The jury is still out about whether or not this is a bear market rally, as I think, or whether we are in a new bull market, even if I was too conservative.

On May 09 10:52 AM Ranger wrote:

> Nice try to cover for your faulty market prediction. A person could
> do exactly the opposite of what you suggest and do all right in the
> market. You're another Cramer...nothing more. Maybe that market wizard
> Henry Blogett will let you on his show.

May 09 01:43 PM

[ArtfulDodger:]

Good comment! Good points.


On May 09 11:33 AM Prudent Man CFA wrote:

> Why would anyone buy a stock in a company, especially a bank, that
> is kept alive by government intervention?
>
> Interesting that the companies begging for equity are still managed
> by the incompetents who virtually bankrupted them.
>
> I can hear the Goldman Sachs' millionaire peddlers calling their
> institutional investors and telling them what a great financial stock
> they have for them while they are shorting it. So much for fiduciary
> responsibility. Forty years ago they would have been put out of business
> and those were the days you could believe a financial statement.
>
>
> BHO superficially wants to stop the boom and bust cycles - a desire
> of every Socialist who hates Free Enterprise because the statists
> can't control it. He can start with honesty - his, his Administration
> and the financial industry.
>
> If anyone wants to pay back the TARP I will believe them when they
> put the money in an independent escrow account. Money talks and b.s.
> walks!
>

May 09 02:33 PM

[capt Brian:]

blind leading the blind, Have not heard any advice, just will should could would.

not nice things coming. I am gonnna print out all my comments, and make a book. I think I am gonna be real right, and with any luck at all, I will be dead wrong about the coming storm.

The lost navigator

Capt Brian

May 09 11:41 PM

[RWRocksOn:]

Vulcan certainly has a lot of debt, but their debt covenant calls for total debt to capital less than 65% and they are at 50% and have all ready written down a billion of the Florida Rock goodwill. In addition, 30% of the Florida Rock purchase was with Vulcan stock that was also topped out (I think at $113). The rest of the deal was cash which may or may not have been a good idea - a normalized economy will tell. I do not agree with all their capital allocation decisions - the decision to continue issuing a dividend while selling WEB 10% plus bonds strikes me as a bit strange.

May 16 08:42 PM