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Let's Be Careful Out There - Sentiment in Secondaries

(Guest Commentary by Rick Konrad – April 8, 2010)

Dear Subscribers and Readers,

For those who had want learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for a few years now and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will discuss the dramatic rise in secondary offerings in the first quarter of 2010 – and more importantly, its implications.  While Rick believes the stock market is nowhere close to a major peak, he nonetheless argues that there are many signs of short-term excesses, and then we should now be wary, at least in the short-term.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see "St. Patrick's Day and the Dash for Trash" for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

As you know, Henry recently reduced his exposure to equities by 50% primarily due to a buildup of negative divergences which he has explained in a recent post. Though I generally do not have the freedom to raise my cash allocation to levels that Henry has employed, I have had a similar sense of “easy money” and certainly of clients who wanted greater equity exposure or more risky exposure. In recent discussions, I have cited the dash for trash, in particular the volume of trading that has taken place in what I often refer to as the $2 dollar window.

Speculation has abounded in low priced stocks including names such as Ambac, Fannie and Freddie preferred, and even the last remnant of General Motors, the worthless, Motors Liquidation Company, which at 56 cents, trades an average of about 2 million shares a day.

These are never healthy signs in a market when the appetite for risk reaches into the dregs, at least for the short term. Long term, I remain quite positive in the outlook. One of my friends, Zach Karabell wrote a wonderful article for today's Wall Street Journal outlining many reasons why the long term outlook should remain quite positive. Here is a link to that article. (subscription may be required)

Many of his observations have been true for some time. For example:

“But even so, the Dow is only up 6% year to date, while global and emerging markets—where growth is humming—have done worse. U.S. mutual funds have seen inflows into bond funds and outflows from domestic equity; investors have withdrawn $2.6 billion more than they put in, which means that the "average" investor isn't acting at all bullish. Money-market funds, which are yielding basically nothing, still have $3 trillion, though outflows have been picking up.”

“What's more, U.S. corporate balance sheets are as flush with cash as they've ever been, in the neighborhood of $2 trillion. Conservative and cautious, companies haven't been quick to spend that stash. They haven't been buying back stock (which would be good for the market); they haven't been undertaking aggressive spending (good for other businesses); they haven't boosted dividends; and they haven't been hiring. “

The essence of the bullish argument really revolves around the poor competition that fixed income (particularly for quality) represents. Equities become the only show in town when the alternatives offer little return.

This represents a humungous problem for large pension plans. For example, in today's news, the Ontario Teachers ‘Pension Plan revealed that they had completed a terrific year, well above their benchmark. But the low interest rate environment expands the size of the long term liability that a pension fund's promise represents. Essentially, the present value of the obligation goes up as interest rates go down. Sure, the last few weeks have represented some relief, but nevertheless, rates today are piddling relative to rates ten and twenty years ago. As the Toronto Star observed:

“Despite one of its best years in the markets, the giant Ontario Teachers' Pension Plan is projecting a $17 billion shortfall in the assets and contributions required to pay benefits over the next 70 years.”

“President Jim Leech said Tuesday that managers beat market benchmarks to post a 13 per cent or $10.9 billion rise in the value of invested assets during 2009.”

"The fund's preliminary funding valuation shows a $17.1 billion shortfall, resulting primarily from historically low real interest rates, which continue to prevail."

The quandary of the equity environment at least for the near term is confounded by the abiding market sentiment that continues to make it difficult to commit too high an allocation to equities.  I see some evidence of cavalier risk taking in the market of secondary offerings.

Much academic work has focused on the IPO (Initial Public Offering) market, the new issue market. Not as much work, in my opinion has looked at secondary offerings. A secondary offering is a follow-up offering. The company is already public but wishes to refinance or raise additional capital. Secondaries offer additional stock to shareholders, diluting existing shareholders. There are some secondary offerings where insiders utilize the opportunity to sell large blocks of stock in the market to reduce their position. I have made no effort in this analysis to differentiate secondaries offering additional stock from those where insiders are selling.

The secondary market has come back fairly strongly in the first quarter. Here is a look at the number of secondary offerings that were actually priced (sometimes these offerings are withdrawn due to poor market conditions.) Here is a look at the first quarter results for a number of years.

Q1-Year Number of Secondary Offerings
2010 93
2009 21
2008 140
2007 209
2006 225
2005 210
2004 248
2003 34
2002 91
2001 50
2000 104
1999 15
1998 24
1997 38
1996 16

Though clearly the middle part of this decade represented a bloated calendar for secondary offerings, the first quarter of 2010 has provided a very quick resurgence in this underwriting, and a surge versus 2009.

It is also quite instructive to examine the “quality” of the issues as well as their performance.

Please check this link for an analysis of the non-bulletin board secondary offerings that have been underwritten so far this year.

Only 32 of the secondaries outperformed the Russell 2000 index, or 39%. The median performance for a secondary in this sample was up about 4% whereas the median Russell performance was up about 9%.

Only 27 of the secondaries had been profitable in the trailing twelve months prior to the secondary or 33%. In other words, two thirds of the time that  investors put capital into a secondary offering, it was in a money-losing company.

Only 44 of the secondaries were trading at $5.00 or more, representing 54% of the total. Five dollars is an important threshold for investors representing stocks that can be used for margin purposes. Consequently almost half of these companies were very junior.

Assuming that all of these secondaries were not offering insiders' stock and represented additional stock for the company, fully 67% of these offerings had dilution greater than 10%. This represents very significant dilution for existing shareholders.

I believe that the resurgence of the secondary market, particularly utilizing what I would deem to be rather low quality kinds of names, provides additional evidence for somewhat heady market sentiment.

As they said in the old TV program, Hill Street Blues, “Let's be careful out there!'

Disclaimer: I, my family, and clients do not have a position in any of the securities mentioned in the spreadsheet.

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