In Shell Games: On the Stock Price Performance of Shell Companies, Ioannis V. Floros and Travis R. Sapp examine the stock price performance of shell companies over the period 2006 to 2008. Floros and Sapp’s findings are quite amazing:
When a takeover agreement is consummated, shell company three-month abnormal returns are 48.1%.
What’s a shell?
The SEC defines any company with “no or nominal operations, and with no or nominal assets or assets consisting solely of cash and cash equivalents” as a shell company. All companies reporting to the SEC must indicate whether they declare themselves a shell company according to Rule 12b-2.
Shell firms are traded either on the OTC Bulletin Board (OTCBB) or through Pink Sheets. According to the authors:
[most] shells come into existence either with the sole intent of merging with unidentified single or multiple companies (these are called virgin shells), after being created with a business plan that fails to materialize (these are called development stage shells), or after selling their operations and assets following bankruptcy (these are called natural shells).
The sole purpose of most shells is to “find a suitor for a reverse merger agreement.”
Why a reverse merger rather than an IPO?
The paper sets out five primary advantages to a reverse merger (RM) over an IPO:
First, by engaging in a RM with an existing reporting shell company, a firm can avoid having to go through the lengthy SEC review process. This can save the firm anywhere from 2-12 months. Second, less legal groundwork is needed, and therefore less legal expense. A RM typically costs $200,000 – 300,000 less than an IPO, and this does not include indirect IPO costs such as underpricing. Third, the firm does not need to time the market since a limited percentage of the total stock is typically traded in the immediate post-RM period. Many IPOs are withdrawn at the last minute due to a perceived lack of interest among investors. Fourth, the private firm’s managers don’t have to spend lots of time doing road shows. And finally, the current owners generally own a large majority of the resulting public company.
How big is the opportunity?
RMs have grown in popularity from only three in 1990 to 236 in 2008, and shell companies are providing fuel for much of this growth. Only 26 of the RMs in 2008 were between two operating companies; the other 210 were shell RMs. There are currently over 1,400 reporting shell companies in existence.
What’s a shell worth?
This is where the rubber hits the road for we deep value folk:
Shells that are already trading in the market typically sell for around $1,000,000 and virgin shells, which do not trade, sell for around $100,000 (Feldman (2006).
Why invest in shells?
The authors found that the stock price of most shell firms “tends to decay rapidly over time. The half-life of shell share prices is 172 trading days, or about eight months.” This leads them to ask why investors continue to hold shell shares and why the number of shell firms growing:
We find that approximately half of all trading shell companies consummate a RM in a given year. Since these firms have no operations, investors must be solely attracted by an expectation of a future RM agreement.
Is that a rational expectation? You bet:
We find a three-month cumulative abnormal return of 48.1%, which far surpasses other target firm abnormal returns in the takeover literature.
Here is a graph showing the abnormal returns for the period 30 days prior to the merger consummation to 30 days after:
And a cumulative version of the same graph:
Be careful of the longer-term performance:
Following a RM, we find that the longer-term performance of the RM firms erases the high initial returns. The average surviving firm earns an annual post-event return of -91.2%. Shell companies engaging in RM transactions attract blockholder investment, largely from insiders or family trusts, which persists beyond lock-up periods. We find evidence suggesting that naked short-selling occurs, mainly after the lock-up period of six months, for at least one-fifth of these firms. We show that this helps explain the decline in returns that begins about nine months after the RM. We also examine liquidity and find increased trading volume and a significant decrease in the quoted spread following a RM.
Here’s a graph showing the long-run performance of the shells following a reverse merger:
This is an interesting graph. It shows a comparison of compound average returns from shells and Special Purpose Acquisition Companies (SPACs), which we previously discussed in the post, Blank checks: Fertile fishing grounds for liquidation value investors:
Floros and Sapp conclude as follows:
Our results present a fascinating choice for investors. Namely, does it make sense to invest in an empty shell firm that has no assets or operations? Our results suggest that such an investment is rational as long as the probability of a RM happening soon is high. In the event of a RM deal, the shell firm returns are substantial. However, the wait can be painful. Over time, the shell burns cash to meet ongoing reporting costs and the share price tends to fall. Being able to identify shells that are more likely to consummate a deal sooner thus becomes key. Also, the extent to which shell firms are an investable alternative asset largely depends upon the depth of this rather illiquid market. Most shell firms have fewer than three market makers and trading tends to be thin and concentrated among a relatively small shareholder base. The median number of shareholders in our shell sample is 57 and on average 12% of shell outstanding shares are held by shell managers. Further, the median quoted half spread is 22.3%, showing that transaction costs for an investment in shell firms are non-trivial. We argue that the substantial average return surrounding a RM is compensation for shell stock illiquidity and the uncertainty of finding a reverse merger suitor. Further, the payoff from a shell investment is marginally sufficient to justify the growth in the number of shells alongside the growing RM industry.
Hat tip Wes and Andy.