Don't invest in rights issue for arbitrage

Subscribe only if you believe in long-term prospects of the firm

If an investor would have subscribed to the rights issue of NCC India that came about 15 months earlier, he would be sitting on a gain of 383 per cent. The extra shares, offered at Rs 20 each, are now trading at Rs 96.6. The company offered seven shares for every six a person owned.

Of 22 rights issues in the market since January 2014, only four are trading at a loss. Nine of these have given returns of over 100 per cent. Shareholders of the recently concluded Tata Motors' issue have seen their investments rise almost 16 per cent in less than 10 days.

This year, companies are more aggressively looking at this option. In the first five months of 2015, six have raised a total of Rs 11,434 crore through this route, much higher than in the past six calendar years. Three more companies - Ashima, Universal Cables and Everlon Synthetics - have received board approval for it.

While the returns on rights issue have been lucrative in the recent past, experts caution on the coming ones. "The gains investors have made are a function of market condition and the discount offered," says Ashish Shanker, head, investment advisory, Motilal Oswal Private Wealth Management. For example, a day before Tata Motors announced details of its rights issue (March 25), its share closed at Rs 527.04. This means the company offered a discount of over 15 per cent. Also, the market has been in a bull run for over a year. Since January 2014, the BSE's benchmark index, the Sensex, rose 40 per cent in April and is currently up 28 per cent. During this period, many mid-cap stocks gave three-digit returns. "If the market is volatile or sees a correction, the discount can be wiped off," says Shanker.

How it works
To evaluate a rights issue, an investor should first understand how it works. A company goes for this option when it wants to repair the balance sheet because it's skewed towards debt or the firm is in a growth phase and needs capital.

"It is a signal that the promoter group sends to other stakeholders, such as lenders, that the shareholders are committed to the business for the long term. This might also lead to improvement in the credit rating, which would result in better availability of funds, at a lower interest rate," says Ajay Bodke, head of investment strategy and advisory, Prabhudas Lilladher.

Unlike a rights issue, most other forms of fund raising - qualified institutional placement, preferential allotment, follow-on public offers or institutional private placement - lead to dilution of promoter shareholding. For this option, the promoter also digs into his or her pocket to get the additional shares, thereby maintaining his/her stake. Also, a rights issue helps the company to reward existing shareholders by offering them shares at a discounted price rather than bringing in new ones during the growth phase.

What and why
Don't rush to subscribe to a rights issue of a company only because 80 per cent of the previous ones were very successful. After all, one is getting the stock of a company and it needs the same amount of due-diligence one needs to do before investing in a business. Experts, therefore, suggest that investors opt for good quality companies, widely tracked by the analyst community.

However, in the case of large companies, the number of shares offered in proportion to the shares investors own are usually limited. In the case of Tata Motors, for example, the investor got six for every 109 owned. GMR Infra offered three for every 14 owned and Tata Power offered seven for every 50. "Though this is easy money and any discount is good, the scope of gain is limited in the case of blue-chip stocks because of the limited share offering," says an independent market analyst.

At times, there's also a window of opportunity to buy the stock on announcement and sell it at a profit after receiving the additional shares. Experts say this always turns out to be a gamble and is like predicting the stock price movement after a month. Usually, when the company announces a rights issue, there's an increase in interest in the stock and the price starts moving up. This arbitrage depends on many factors - the price at which an investor can get the stock, the percentage of the discount offered, the market condition. It takes about a month for the rights issue process to get completed. In this period, the volatility can affect the stock price, taking away the opportunity.

Experts say the decision ultimately comes down to whether the person believes in the company and would like to increase his or her exposure to the business. If there's faith, it even makes sense to increase the stake on announcement of a rights issue.