The Biggest Threat to Value Investors

The Biggest Threat to Value Investors

Value investors use a simple but effective strategy to profit from the stock market: identifying companies whose shares look cheap compared to the intrinsic value of their businesses. When those companies keep moving forward with solid business strategies that succeed in boosting that intrinsic value, their stocks usually recover, giving value investors outsized capital gains.

The big problem that value investors face, though, is that many companies don't live up to their end of the bargain. Instead, some companies do their best to shoot value investors in the foot, often hurting their own prospects in the process. Ill-timed secondary offerings of stock represent a huge threat to the returns that value investors can earn, as essentially they put companies and shareholders on opposite sides of the investment fence.

Beating you when you're down
J.C. Penney
has intrigued value investors for years, as the beleaguered retailer inspires debate from bulls and bears alike. Those who argue that Penney is a value trap point to the company's failed attempt to change its business strategy from its traditional discount model to an everyday-low-price concept, which leaders hoped would reduce the need for costly promotional discounting. After that strategic shift failed to produce the desired results, Penney moved back to its original idea, trying nevertheless to make the most of the billions it spent on store renovations and other capital expenditures. Bullish value investors believe Penney can eventually recapture its lost business, while bears argue the retailer has gone past the point of no return and has little chance of fully recovering.

One roadblock could come from the company's potential need for additional capital. With some sources believing that Penney will need as much as $1 billion in new equity, the possibility of a dilutive secondary offering looms large over value investors.

Why secondaries can be so bad
Secondary offerings hurt investors in two ways. First, they put a company on the opposite side of value investors as it sells shares at rock-bottom prices, flooding the market with stock and usually creating price downdrafts. More importantly, though, after a secondary offering, more shares outstanding means that future gains are spread out across a larger shareholder base. That reduces the amount of profit value investors get -- especially those who bought in before the offering took place.

Given the negative impact of secondary offerings, you'd think that most companies would avoid them at all costs. Yet they turn out to be disturbingly common. Earlier this summer, pharmaceutical company Amarin announced it would offer nearly 25 million shares to investors and underwriters to raise about $150 million. Amarin argued that it wanted the proceeds to help it launch its Vascepa triglyceride drug. But with the offering adding 16% to the company's total share count, shareholders sent the stock tumbling further -- and adding insult to injury was the fact that the company got only about $6 per share though the stock had traded as high as $12.50 late last year.

Allied Nevada Gold also had to turn to the markets for a secondary offering earlier this year, with terrible timing right after a huge plunge in the price of gold. The gold miner got just $10.75 per share for its stock, even though the shares had started 2013 above $30.

Even well-known, large-cap stocks sometimes have to resort to secondary offerings at inopportune times. The financial crisis was rife with situations in which banks had to agree to horrible deals to raise capital. More recently, Bank of America made a dilutive offering aimed not at the public markets but at a single investor: Warren Buffett managed to get preferred shares of B of A convertible to common stock at just above $7 per share and that paid a 6% dividend. With B of A shares above $14, Buffett did well -- but at the expense of the bank's common shareholders.

Smart secondaries
Not all secondary offerings turn out badly, however. When companies are smart about timing offerings when shares are doing well, they can use investor enthusiasm to get favorable results for their businesses. Tesla Motors is an excellent example, as its May secondary offering actually helped boost the stock. Supportive comments from founder Elon Musk and Tesla's use of the proceeds to pay off an Energy Department loan early helped the bullish case for the car company. Based on continued hopeful prospects for the electric-car maker, Tesla stock has continued to soar even after the offering.

Tesla's example, though, is the exception rather than the rule. Value investors need to be on the lookout constantly to make sure that promising prospects won't make dilutive offerings that will sap their growth potential. Otherwise, value opportunities can quickly turn into value traps.

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Fool contributor Dan Caplinger owns warrants on Bank of America. The Motley Fool recommends Bank of America and Tesla Motors. The Motley Fool owns shares of Bank of America and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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