Rights Issues - get it right!

People like me, who are not hyper-active in the markets tend to sit on decent percentage of cash for extended periods of time. While this cash typically earns the regular 7-8% in liquid funds, I keep on looking for ways to improve the return on this large part of my portfolio. Rights issues are a great way (among others!) to put the cash to some use and earn that extra return. If you are lucky, you will earn lots in rights issues. If you are unlucky, you wont lose much! Me likes! My kind of situation. :-)

Here is how it works..

One should not deploy money in each and every rights issue which hits the market. Some basic pointers..
1) The company should be a decent company, not going at atrocious valuations. (Although it doesn't matter if its a bit expensive)
2) The rights issue price should be at a decent discount to the current market price. So, a Bajaj Hindustan will not do, but a Neuland Labs will do!
3) If its an unknown company will less institutional holding, it would be great. (I will clarify why it is so in due course.)

Lets say that A Ltd is coming out with a rights issue. The ratio is 1 share for every 2 shares held. The CMP is Rs.50 and rights issue price is Rs.30. Record date is April 19, 2012 (Ex-date will be April 18).

1) Buy 100 shares of A Ltd. close to the ex-date, on lets say April 15th itself at Rs.50. (So that on ex-date, the shares will be there in your demat account.)
2) On ex-date, the stock price should fall in the proportion as well as price of the rights issue. (Although, in the recent case of Neuland Labs, it did not fall at all!) Lets say here, it falls by Rs.8 to Rs.42.
3) Sell your original shares on ex-date. There would be a total loss of Rs.800. However, since you sold on ex-date, you are still eligible to apply for the rights issue.
4) Now, you can participate in the rights issue. On the original 100 shares, you will get 50 shares guaranteed (1 for every 2 held) at Rs.30.
5) However, while applying for the rights issue, you can always apply extra. Here, lets say that you applied for 950 extra shares. Total application would be 50+950=1000 shares at Rs.30 each.
6) Now, if all shareholders apply for the issue, you will not get anything extra. So, you will get only 50 shares at Rs.30. Lets say you are able to sell them at Rs.42. Thats a total profit of Rs.600. So, along with earlier loss of Rs.800, net-net, there is a loss of Rs.200 on the entire transaction. Since original position is small, the amount of loss is not much, in absolute terms/as a % of portfolio
7) However, if its an unknown company etc, where other shareholders did not apply, you can get extra allotment. Lets say, you got all 1000 shares you applied for, at Rs.30. And you managed to sell them at Rs.42. Thats a profit of Rs.12000! Minus original loss of Rs.800, which gives us a net profit of Rs.11200. Not bad. (I am not considering short term cap gain tax etc to just to keep things simple.)
8) The only risk here is in a situation where you got full allotment, and by the time the allotment was done, the stock price just crashed much below the rights issue price..then you are in trouble. That is why I laid down some basic pointers above.

So if you are lucky (yes, total luck, not skill!), you will get extra allotment and earn decent amount. If you are not lucky, the loss will not be very high, since initial position itself was small.

Some rights issues in which I got lucky in the recent past were Camlin Fine (got HUGELY lucky here!), SBBJ, etc. Others, in which I was not so lucky (no extra allotment) were Veljan, Sadbhav Engg (this one was interesting, since there were attached warrants too), etc. However, there was no loss in the same. Lets see what happens in Neuland!

One tukka in rights issues, where you get massive allotment, can give a huge alpha to your portfolio. e.g. in Camlin Fine, market price was Rs.105 (Rs.10 paid up), while the rights issue was at Rs.15.75!!! I applied a lot extra and for some reason, I got full allotment! Great return, without much analysis or trouble to the brain! Super balle balle.

Hope you get the rights right! Till then..

Cheers and happy investing!!



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