The Hindu Business Line : Discount offers and investors' memory

ING Vysya, Karnataka Bank and Punjab National Bank have offered shares at a considerable discount to the market price. The list of companies issuing shares at a discount could well expand, as many have lined up secondary market offerings in the near future. Corporate finance purists have condemned these discount offerings. Equity, in corporate finance theory, features last in the pecking order because it is the costliest form of financing. Naturally, then, offering equity at a discount is sinful, as it is likely to have a greater adverse impact on the company. But this argument may not be true.

Pecking-order hypothesis: Equity is risky. So, investors demand a premium over the risk-free rate. Corporate finance purists, hence, contend that companies should first issue bonds, use internal accruals and only then consider equity to fund their projects. Cost of equity is the return investors' expect from buying the company's stock. In the capital-asset pricing model (CAPM), the risk premium is captured by the stock beta, which is the co-movement of the stock with the market.

The problem is that the tail events or severe price declines are averaged out in the computation of the stock beta. That is why the expected returns under the CAPM are low compared to the actual returns. This has been dubbed as the "equity premium puzzle". But investors do not demand a high risk premium because a stock is, on an average, risky.

Investors are more bothered about the tail events, which are more frequent than is captured by the Gaussian distribution. The market crash last May is not an aberration. Such crashes will happen frequently as long as markets exist. The risk premium is, hence, a function of the downside risk. The lower the price, the lower the risk because stock prices are bounded on the downside (they cannot decline below zero). A discount offering ought, therefore, to carry a lower risk premium, meaning lower cost of equity!

Short memory process: The logic may seem twisted. A discount offering could signal that the management perceives that the stock price is overvalued. The existing investors who bought the shares at higher prices could, hence, trigger the tail event risk, leading to higher risk premium.

The problem is that this argument assumes that investors have long memories. When a company offers fresh equity, the EPS will decline. So, investors will mark down the company's stock price. If the offer is at a discount, more shares will have to issued, meaning even lower EPS and stock price. But this presupposes that investors continually rewind their memory to the discount offering and refuse to mark up the stock even if the new information is positive for the company.

Empirical evidence suggests that investors do not have long memories. If they did, they would learn from mistakes. Market crashes, for instance, will not happen frequently.

Investors are primarily traders. The long-term investors, perhaps, start as short-term traders and then extend their horizon because they suffer from loss aversion. Investors buy stocks, driven by new information that has just arrived and/or information that is likely to arrive. Importantly, the investment decision is not driven by past information. Investors have short memories, especially in a trending market, as they ignore negative news and only impound positive information into the stock price.

Discount vs premium offering: If companies were to make primary offers close to the market price, why would investors buy them? The margin of safety, captured by the discount to the market price, may not be enough to compensate for the time risk. This is the risk that the market price will decline before the new shares are allotted to the investors.

The fact is that primary offerings are termed cheap or costly relative to the market price. And that is linked to the market conditions. Primary offers look pricey when the market is trending down and very cheap when the market is trending up.

(Feedback can be sent to bvenky@thehindu.co.in)

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