A Survey In Seasonal Equity Offerings

A Survey in Seasonal Equity Offerings

Fangzhou “Ark” Shi

December, 2007

Abstract
We survey researches on seasonal equity offerings since 1980s, concentrating on United States. Literature on stock performance patterns, operating performance patterns, and the relationship between them are reviewed. We also review the new results in pecking order model, trade-off model, market timing model and other new models both theoretically and empirically. Researches about other sophisticated equity markets are also briefly discussed.

1. Introduction

Since 1980s, more new anomalies of seasonal equity offering (SEO) have been found in empirical research. At the same time, more theories and explanatory models have appeared addressing these anomalies. We survey empirical evidence of stock performance anomalies and operating performance concerning firms conducting SEOs in the recent twenty years. The relationship between these two performances has been a futile field and typical results are briefly discussed in this paper. Main theories - pecking order model, trade-off model and market timing model – about SEOs with their empirical tests are also reviewed in this paper. The nearest ten years include more and more empirical conclusions about SEOs. New empirical evidence and the theory background are included, too. For those papers which have a contribution to the research methods in SEOs, the important concern and ideas are also be discussed. To give a general image of the SEOs in world’s sophisticated equity markets, we briefly show some research results.

Having indicated what we do in this paper, it is also necessary to point out what we do not do. Newer models concerning capital structure are not surveyed, unless they have a direct relationship with SEO actions. Most of evidence before 1980s is not covered in this paper. Conclusions specific about initial public offerings cannot be found. But results about general equity issue are briefly discussed. Because the well understanding of traditional models, we do not talk in detail about traditional pecking order model and trade-off model. We do, however, briefly review the market timing model.

Section 2 will survey the empirical results about stock performance and operating performance of firms conducting SEO. Section 3 to section 4 describe report the theories and empirical results of pecking order model, trade-off model, market timing model and new explanations. Papers addressing international comparisons will be reviewed in section 5.

2. Stock Performance Patterns and Operating Performance Patterns

2.1 Stock Performance of Firms Conducting SEO

There have been lots of papers documenting the change in price and stock return for firms going public. Here we just start from those focused on SEO issues.

Dating back to 1980s, Asquith and Mullins (1986) and Masulis and Korwar (1986) have shown that there is a high stock market valuations that increase markedly before the SEO.
The former paper, using 531 registered common stock offerings by utilizes and industrial firms, demonstrate that announcement of common equity offerings reduce stock prices. Also, although the average announcement day excess return for all industrial issues is only -2.7%, registered secondary distributions of industrial stocks are accompanied by a reduction in firm value equal to 78% of the proceeds of the sale, which is a very big ratio. Masulis and Korwar (1986) apply event study method for company announcements reported in the Wall Street Journal Index and the Investment Dealer’s Digest over the period 1963-1980. It indicates that on average, a negative stock price change is observed, which is larger for industrials than for public utilities, after the announcements of underwritten common stock offerings. Combination primary-secondary stock offerings and dual stock-bond offerings exhibit similar negative announcement effects.

To test whether offer prices are set below the price prevailing the day before the formal issue, Loaderer, Sheehan, and Kadlec (1991) compare the offer price with preoffer close price. They find out underwriters do not systematically set offer prices below previous transaction prices, except possibly in the NASDAQ market. Contrary to their hypothesis, underwriters do not take into account the savings in transaction costs and price the issue above the previous ask price. Regarding holding returns about the issue day, they find out that quick round-trip transaction in seasoned offerings are not profitable, but subscribing to an offering and holding the stock for 30 days seems to be very profitable.

This evidence about the announce period returns is consistent with several other research, which author SEO occur on average after substantial price runups and there is a 3 percent price drop on average when an SEO is announced. But it is also interesting to examine the long-term postissue performance. Stigler (1964) shows that there is a significant difference between preissue sample price and postissue sample price in the third and forth year after the announcement. Friend and Longstreet (1967) also get similar evidence using small samples. They both show that issuing firms do poorly in the long run.

Nevertheless, not many researches had documented the long-term underperformance until Loughran and Ritter (1995). In the famous paper “The New Issues Puzzle”, they use a sample of 3,702 seasoned equity offerings during 1970 to 1990 and find out that companies issuing stock through SEO significantly underperform relative to nonissuing firms for five years after the offering date. The result is robust to different procedures to calculate the statistical significance. Also, the magnitude of this underperformance is not only statistical significant, but also economically important: based upon the realized returns, an investor would have had to invest 44 percent more money in the issuers than in nonissuers of the same size to have the same wealth five years after the offering date. Similar result can be found in Spiess and Affleck-Graves (1995). They document that firms making seasoned equity offerings during 1975-1989 substantially underperformed a sample of matched firms from the same industry and of similar size that did not issue equity. The underperformance persists even after controlling of trading system, offer size, and the issuing firm’s age and book-to-market ration.

So far, we have only talked about the price change for firms conducting SEOs, links between the stock price performance and the operating performance is in need to get a clearer picture of the empirical evidence concerning SEO.

2.2 Operation Performance of Firms Conducting SEO

Initiated by the incentive to test whether the well documented stock price declines are due to information conveyed, Healy and Palepu (1990) use the same industrial firms sample as Asquith and Mullins (1986). They find that offer announcements do convey information about future risk changes since they are accompanied by increases in asset betas and decreases in financial leverage. However, they do not convey new information about offer firms’ future earnings levels. Contrary to this result, Hansen and Crutchley (1990) find a statistically significant postissue decline in return on assets for their sample of 109 issuing firms during 1975 – 1982. They use three methods of measuring the expected earnings changes to compute average abnormal earnings and find that there are negative abnormal earnings in the year of and for several years following offerings of common stock, straight debt, and convertible debt.

McLaughlin, Safiedddine, and Vassudevan (1996) analyze a sample of 1,296 equity offers during the period 1980-1991 for changes in operating performance. Their sample of SEO firms has significant improvements in operating performance prior to the issue. And these firms experience a sharp, statistically significant decrease in profitability following the SEO in both industry-adjusted and unadjusted comparisons. In addition to that, they report that the decline in profitability is greater for firms that have higher free cash flow, and that SEO firms that invest in new fixed assets perform better than SEO firms that do not.

Similar evidence can also be found in Lougharan and Ritter (1997). The article documents the poor postissue operating performance of firms conducting 1,338 seasoned equity offerings during 1979-1989. They find that many of the issuing firms have improvements in profitability before the offering and there are material and persistent declines in operating profitability beginning immediately after firms conduct SEOs. The fact that firms issue following a transitory improvement in operations is fully consistent with a semi-strong form efficient market, as the Signal-jamming model from Stein (1989) Moreover, based on the result, new equity offerings can be used to forecast poor subsequent operating performance: the profit margin and return on assets for the median issuer are cut approximately in half within four years of the offering. The deterioration is much larger than for nonissuers matched by asset size, industry, and operating performance. They also show that the degree to which issuing firms underperform varies over time: firms issuing during years when there is little issuing activity do not underperform much at all, whereas firms selling stock during high-volume periods severely underperform.

Combining empirical evidence of stock performance, we can see that the subsequent deterioration in the operating performance is reflected in low postissue stock returns. Just as the existence of inconsistent empirical evidence, the interpretations and implications of these evidence, which will be discussed in the next section, are also, or even more controversial.

2.3 Interpretation and Implication

Regarding the empirical results of stock performance and operating performance, we are interested in whether there is an independent issuing effect. Several papers address the concern for other “noises” of the above empirical results and the test of these assumptions.

The first concern is the confounding effect hypothesis. According to the definition in Lougharan and Ritter (1997), it is that the low postissue stock returns on issuing firms are merely a manifestation of the fact that most issuers are rapidly growing. Dreman (1982) and Debondt and Thaler (1985) motivate their empirical work on stock market overreaction by describing work by psychologists including Kahneman and Tversky (1982) documenting widespread tendencies for humans to overweight recent experience at the expense of long-term averages. Whether or not there are tendencies for the stock market to overextrapolate recent growth is controversial. Lakonishok, Shleifer and Vishny(1994) try to find the appropriate interpretation of why value strategies produce higher returns. They find out that market participants appear to have consistently overestimated future growth rates of glamour stocks relative to value stocks. Thus, a likely reason that these value strategies have worked so well relative to the glamour strategies is the fact that the actual future growth rates of earnings, cash flow, etc. of glamour stocks relative to value stocks turned out to be much lower than they were in the past, or as the multiples on those stocks indicate the market expected them to be. However, Dechow and Sloan (1997) examine the ability of naïve investor expectations models to explain the returns to contrarian strategies. And they find no systematic evidence that the returns to contrarian strategies arise because investors naively extrapolate past sales or earnings growth. Over 50% of the returns to the contrarian strategies can be attributed to investors’ naïve reliance on analyst’s long-term earnings growth forecasts. Since issuing firms tend to be high-growth firms and have low postissue stock returns, Lougharan and Ritter (1997) suggest the test of the above confounding effect. Their cross-sectional tests of the relation between firm growth and subsequent stock returns show that issuers have lower market-adjusted returns than nonissuers, on average. While the high-growth firms tend to have lower market-adjusted returns within a category, issuers almost always do worse than nonissuers. These conclusions are not very sensitive to be return metric employed. So according to Lougharan and Ritter (1997), the noise of confounding hypothesis does not have too much power.

Also based on the empirical results, we find that investors, who receive low postissue stock returns, and managers, who rapidly increase capital expenditures, appear to be too optimistic about the prospects of issuing firms. Suggested by Lougharan and Ritter (1997), analyst forecasts are direct measure of expected postissue operating performance. Ali (1997) indicates that the postissue earnings forecasts are systematically too optimistic. Healy and Palepu (1990), Brous (1992), and Jains(1992) all analyze the reaction of forecasters when companies announce stock issues. They find that only tiny revisions in their earnings forecasts are made. In addition, papers discuss the market reaction, such as Korajczyk, Lucas and McDonald (1991) and Cheng (1995), show that market is surprised by future earnings announcement. Inspired by the research results, we are wondering whether the overestimate of the profit potential of issuing firms is partly due to that firms have “managed” earnings. According to Lougharan and Ritter (1997), this is also a potential noise. In terms of the research concerning this hypothesis, Teoh, Welch, and Wong (1997) and Rangan (1997) report that issuers with high levels of discretionary accruals have the worst subsequent stock returns. However, Lee (1997) find there is a lack of massive insiders selling for issuers. This result supports the view that managers have not consciously attempted to manipulate.

Besides the confounding effects and earnings management, there are also alternative explanations. Agency problem is also an important concern. As indicated by Jung, Kim, and Stulz (1996) and McLaughlin, Safieddine, and Vasudevan (1996), the cash inflow and reduced managerial percentage ownership associated with an equity issue may intensify agency problems and result in lower operating margins. Lougharan and Ritter (1995) also concern the possibility that poor subsequent performance is merely a manifestation of long-term return reversals. They show that the poor performance of issuers is not merely proxying for long-term return reversals, and book-to market effects can explain only a modest portion of the low returns.

To sum up, most of researches agree that there is strong, independent issuing effect: issuers have much lower subsequent stock returns than nonissuers with the same growth rate.

3. Pecking Order and Trade-off Model

Pecking order model and trade-off model are two traditional interpreting models for the capital structure. So far, many papers are addressing the empirical test of these two models. We will start from the general weakness of the two models, and then move on to those tests concerning SEOs.

The most well document shortcomings of the trade-off and pecking order models come from Frank and Goyal (2003), Fama and French (2005), and Welch (2004). Frank and Goyal (2003) test the pecking order theory of corporate leverage on a broad cross-section of publicly traded American firms for 1971 to 1998. They find out that external financing is heavily used but debt financing does not dominate equity financing in magnitude. Net equity issues track the financing deficit quite closely, while net debt does not do so. Fama and French (2005) indicate that most firms issue or retire equity each year, and the issues are on average large and not typically done by firms under duress. Therefore, financing decisions violate the central predictions of the pecking order model about how often and under what circumstances firms issue equity. Both of these two papers show that external equity is not the financing vehicle of “last resort”, as predicted by Myers and Majluf (1984) pecking order model. Also, Welch (2004) concludes that over reasonably long time frames, the stock price effects are considerably more important in explaining debt-equity ratios than previously identified proxies. When stock returns are accounted for, many other proxies used in the literature play a much lesser role in explaining capital structure.

There are also some papers addressing the weakness of explaining power of pecking order and trade-off model in equity issuance without defying the general model. Hovakimian, Opler and Titman (2001) report evidence of rebalancing, but conclude that the evidence is markedly weaker when the capital structure change includes an equity issuance. Hovakimian (2004) finds there are some signs of systematic leverage rebalancing, but nor for firms that issue equity. The deviation between the actual and the target ratios plays a more important role in the repurchase decision than in the issuance decision. Similar conclusions can be found in Leary and Roberts (2005), where they find that, although firms generally tend to rebalance toward a target ratio, equity issues are a prominent exception, thus they are anomalous for the trade-off theory of capital structure.

Empirical research in the test of the two traditional models using SEO data also has fruitful results. Korajczyk, Lucas and McDonald (1990) and DeAngelo, DeAngelo and Stulz (2007) both find that issuers’ leverage does not increase significantly in the two years before an SEO. Loughran and Ritter (1997) also find results that cannot be explained by Myers (1984) pecking order model. Firstly issuers have low postissue stock returns. Secondly, many firms issue equity when they apparently aren’t constrained to. Lougharan and Ritter’s (1995) result implies that market is inefficient. Then pecking order may be violated if market doesn’t have a low enough expectation. All of these results are against the pecking order model. Asquith and Mullins (1986) Masulis and Korwar (1986) The result, high stock market valuations increase markedly before the SEO from Asquith and Mullins (1986) and Masulis and Korwar (1986), is also not consistent with the traditional trade-off and pecking order models.

Compared to the multiple weakness evidence of the pecking order and trade-off model, empirical support for them is relatively scattered, but still worth taken significant consideration. Fama and French (2002) partially confirm some predictions shared by the trade-off and pecking order models from the perspective of dividend payout. Flannery and Rangan (2006) indicated that firms do have target capital structures with the partial-adjustment model. Kayhan and Titman (2007) also show that firms tend to rebalance leverage toward a target optimum, although the adjustment process is slow, typically taking some three to seven years or more. With a new econometric technique to deal with biases in estimates of the speed of adjustment towards target leverage, Huang and Ritter (2007) find that firms adjust toward target leverage at a moderate speed, with a half-life of 3.7 years for book leverage, even after controlling for the traditional determinants of capital structure and firm fixed effects. The support specific to SEOs is even rarer. So far, we only have Masulis and Korwar (1986) report comparably modest SEO-induced leverage changes for offerings conducted over 1963 – 1980.

The shortcomings of pecking order model and trade-off model inspired not only new explanatory models which we will talk about in the next section, but also revision to the traditional models. With the dynamic pecking order from Stein (1996), which means sometimes the ranking of choices is external equity, external debt, and internal equity, we can explain some anomalies of traditional models, such as those we talked about from Loughran and Ritter (1997).

In general, traditional pecking order model and trade-off model are weakened by several empirical evidences. Especially in terms of SEO, more shortcomings with less support have been found so far. This inspires us to find new explanatory models, among which market timing model seems to be the most supportive one. We will review the literature of this field in the next section.

4. Market Timing Model

Given the well-documented empirical shortcomings of the trade-off and pecking order models, market timing is currently the most strongly supported. The general idea is that firms take advantage of transitory windows of opportunity by issuing equity when, on average, they are substantially overvalued. The intention is to exploit temporary fluctuations in the cost of equity relative to the cost of other forms of capital. Ritter (1991), Loughran and Ritter (1995, 1997), Baker and Wurgler (2002) are well considered as the main papers supporting the pure market timing model. Ritter (1991) mainly focuses on IPOs of common stock and finds that the concentrations in volume in certain years are associated with taking advantage of “windows of opportunity”. Ritter (1995, 1997) provide empirical evidence that underperformance of stock price and change in operating performance of firms experiencing SEOs. However, this is only consistent with market timing models to some extent. Whether issuers are knowingly selling overvalued equity is still controversial. Baker and Wurgler (2002) conclude that capital structure is the cumulative outcome of past attempts to time the equity market. All of these papers indicate that firms are taking advantage of the opportunity time to augment what Myers refers to as financial slack wave.

Around the same time as Loughran and Ritter (1995), regarding the economically significant long-run underperformance that follows seasoned equity offerings, Spiess and Affleck-Graves (1995) also suggests the explanation that managers are able to determine when the market is willing to overpay, or is currently overpaying, for their stock, and that they take advantage of these opportunities to issue equity, given the restrictive explanatory power of irrational market story.

Several recent empirical studies propose combined explanations with market timing model and other models. They are not pure market timing advocates but also lead support to it. Huang and Ritter (2007) indicate evidence for both market timing model and static trade-off model. They examine time-series patterns of external financing decisions and show that publicly traded U.S. firms fund a much larger proportion of their financing deficit with external equity when the cost of equity capital is low. Kim and Weisbach (2007) find that one of the motive of equity offer is to raise capital for investment, but firms also hold onto much of the cash they raised, and this fraction is higher when the firm has a high q. These results suggest that market timing as well as investment financing is a motivation for equity offers. DeAngelo, DeAngelo and Stulz (2007) show that market timing is not the primary motivation for selling stock, but still a secondary influence that systematically impacts SEO decisions. What’s more, one subset of their sample firms stockpiles the proceeds. It is consistent with “pure” market timing theories.

There are also some concerns about the market timing theories. Lucas and McDonald (1990) indicate that firms which are undervalued postpone equity offerings. An equity issue announcement is associated with the market revaluing the firm. If market timing model works, that means market does not revalue it appropriately. DeAngelo, DeAngelo and Stulz (2007) address another concern. Following market timing model, if we assume company had a conservative dividend policy, a small sample of mature firms may have enough cash to avoid equity issue. But this is not practical. Big stockpiling by mature firms is empirically rare and the most plausible explanation is that large cash balances foster agency costs, as Stulz (1990), DeAngelo, DeAngelo and Stulz (2006) and DeAngelo and DeAngelo (2007)

To sum up the empirical evidence about market timing models, we use the generalization from Baker and Wurgler (2002). There is evidence for market timing in four different kinds of studies. First, analyses of actual financing decisions show that firm tend to issue equity instead of debt when market value is high, relative to book value and past market values, and tend to repurchase equity when market value is low. Second, analyses of long-run stock returns following corporate finance decisions suggest that equity market timing is successful on average. Third, analyses of earnings forecasts and realizations around equity issues suggest that firms tend to issue equity at times when investors are rather too enthusiastic about earnings prospects. Fourth, according to Graham and Harvey (2001), managers admit to market timing in anonymous surveys. All of these evidences apply to seasonal equity offerings.

5. Other Explanatory Theories

Besides the most famous pecking order model, trade-off model, and market timing model, there are also distinct theories to explain the stock performance and operating performance of firms conducting SEOs. These theories are not necessary to go against the traditional viewpoints. Usually, they are making compromise of competing theories. And the new ideas about the revision process are by themselves interesting.

In last session, we have already reviewed Huang and Ritter (2007). They show evidence of both static pecking order model and market timing model. Kim and Weisbach (2007) emphasize that both investment and market timing are motives for equity offers.

Carlso, Fisher & Giammarino (2006) use a real options framework with rational expectations and dynamically consistent corporate decisions. They find that SEOs may appear to be driven by market timing. But in fact the typical pre-SEO stock price increase simply reflects an increase in the value of issuers’ profitable growth options. This potion views are typically new to analyze SEOs of firms.

Baker, Stein, and Wurgler (2003) look at the relation between investment, market valuation, proxies for fundamentals, and the behavior of investment during the episodes associated with the crashes of 1929 and 1987. They find a limited role of market valuation, given fundamentals. Combined with Blanchard, Rhee, and Summers (1993), the evidence show that market timing is not the primary motivation, but nonetheless influence financial decisions. Also they inspire the further pursue in fundamental explanations.

Following this idea, DeAngelo, DeAngelo and Stulz (2007) continue to analyze the SEOs from the perspective of fundamental need. They find that without the SEO proceeds, most of issuers would have insufficient cash to implement their chosen operating and non-SEO financing decisions the year after the SEO. Although the SEO decision is positively related to a firm’s market-to-book (M/B) ratio and prior excess stock return and negatively related to its future excess return. These relations are economically immaterial. So firms conduct SEOs to resolve a near-term liquidity squeeze, and not primarily to exploit market timing opportunities.

Another very important contribution of DeAngelo, DeAngelo and Stulz (2007) is that they show a serious problem for studies support market timing theory: they focus exclusively on how the share prices of firms that actually choose to issue stock. Behave around the time of the SEO. According to DeAngelo, DeAngelo and Stulz (2007), very few firms with highly favorable market timing opportunities actually issue stock. The propensity to issue of these firms exceeds only trivially that of firms with no such opportunities. In another words, we used to consider the “dogs that bark”, but the fact is that many “dogs don’t bark”. This problem with the traditional research may initiate more revision of the old theories and invention of new models.

6. International Comparison

Empirical studies of international SEOs are relative scatter. And most of them are about United Kindom. and Japan, which are considered among the world’s most sophisticated equity markets. It is probable because the patterns documented in the past research are not unique to the United States. Levis (1993) reports that firms which conduct seasonal equity offerings in the United Kingdom subsequently underperform. Marsh (1979) reports that firms conducting SEOs in the United Kingdom during 1962 to 1972 outperform the market during the following year and then underperform in the second year after the offering.

Besides, Levis (1995) shows that the announcement of a seasoned equity offering follows a period of significant rises in the stock prices of reissuing firms. Such gains are dissipated quickly in the 18 months after the announcement of the seasoned equity offering. Kang, Kim, and Stulz (1996) explore the long-term performance of security-issuing firms in Japan. They find underperformance for Japanese firms issuing convertible debt or equity even though these firms do not experience significant negative abnormal returns when the issue announcement is made. These two papers and Cai (1996) together indicate that investment performance of SEOs in the United Kingdom and Japan is virtually identical to the US patterns

7. Conclusion and Direction for Future Research

In this paper we review existing research in seasonal equity offerings. Research results are consistent in the empirical evidence about the stock performance and operating performance of firms conducting SEOs. But the explanation of stock performance, operating performance, and the relationship between them are still controversial. More shortcomings of the pecking order model and trade-off model are documented. Even with current strong support, market timing model is also facing more suspects and compromises.

The literature on seasonal equity offerings tells us much about theories and empirical evidence in SEOs but the message in the information is far from complete. New finding about the anomalies inspire us to revise traditional models and compromise existing theories. Investment, squeeze in cash, and other fundamentals are considered as more and more important in explaining the SEOs. One direction of the future research is to continue pursue significant explanatory variables. Another direction, which may seem to be more insightful, is to discuss what factors influence the relative importance of these variables. To some extent, the idea is similar to the move from static pecking order model to the dynamic pecking order model. More question, such as the predictability of general model, the can be asked following this idea.

At the same time, realizing the misuse of sample choice and analyzing method in the past may render us pursue for new explanatory models. Especially for the old articles about market timing model, considering the “barking” problem from DeAngelo, DeAngelo and Stulz (2007) asks for a reconsideration of past biased results.

In terms of the international comparison, more empirical work is in need focusing emerging equity markets. Do firms conducting SEOs in these environments have similar patterns of stock performance and operating performance? What kind of influencing factors of SEOs is comparatively more important? What is the special affecting mechanism? Is there a convergence in these performance patterns? What kind of new model can explain the anomalies there? Answers to these questions will increase our understanding of the role of SEOs throughout the world.


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