Why Follow-Ons Are a Red Flag

News of a follow-on equity offering is almost never received well by shareholders, and stocks typically fall on the day of the announcement. But studies also show that the negative effects of a secondary offering can actually last for years.

Companies issuing additional shares have historically underperformed nonissuing companies by 3.4% in the five years following the offering, according to Jay Ritter, professor of finance at the University of Florida.

That's potentially bad news for Activision(ATVI Quote) -- which sold new shares Wednesday -- and for the 267 other U.S. companies that have conducted follow-on offerings so far this year.

Although the rationale behind a stock sale varies depending on the firm, in almost all cases companies issue more shares because they are unable to generate the necessary cash from current operations to fund or grow their business.

Ritter notes that stocks fall 3% on average on the day a follow-on announcement is made because investors realize that additional stock can dilute existing ownership and earnings. Secondary offerings often go hand in hand with insider selling, which can also indicate that the company is in trouble, he said.

In addition, equity issuance is interpreted by some investors as a sign that shares are overvalued. Companies that conduct a follow-on, or seasoned equity offering, as it is also known, typically do so when valuations are rich.

Activision, for example, has surged almost 48% over the past year while Accenture(ACN Quote), which sold an additional $1.8 billion worth of stock last month in one of the largest follow-on offerings so far this year, is up almost 30% from its initial public offering last year. Ritter said stocks typically show an average return of 72% in the year prior to the offering.

Tim Loughran, associate professor of finance at the University of Notre Dame, who co-authored a study on this subject with Ritter, also noted that profit margins are usually "very good" before a stock sale.

The positive momentum generated by these results often carries over for an additional six months after the offering is made. In fact, Ritter said stocks usually outperform by about 2% over the following two quarters.

"Companies are very careful to meet earnings expectations," he said. "This can sometimes mean finagling earnings and borrowing from future quarters to meet current estimates."

Within one or two years, though, the shares begin to underperform as margins deteriorate and companies typically issue a profit warning.

Stocks that have not seen a sharp rise in share price but which have nonetheless sold shares this year include AT&T(T Quote), which issued $2.25 billion of stock Wednesday night despite having fallen 46% in the last 12 months.

Timothy Curtiss, chief operating officer at Wall Street Investor Relations Corp., said some companies are so financially troubled that they have no choice but to sell stock. That certainly holds true for a number of energy traders like Dynegy(DYN Quote) and Mirant(MIR Quote), which have issued equity in order to shore up their balance sheets in the wake of Enron's collapse.

But stock offerings can also suggest that a firm's fortunes are about to improve as it sees opportunities to invest new capital.

Of course, the performance in share price following the offering depends heavily on how well the company can convince shareholders that it will invest the money wisely.

In the short term, "holders and traders sell shares because they know they can buy them back at a lower price when the offering is done," said Curtiss, who has been involved in selling secondary offerings over the last 15 years. Still, he noted that if the deal is well promoted, shares may actually rise a little.

In fact, Curtiss believes that in some cases, a follow-on offering can be a good investment. DaimlerChrysler(DCX Quote) tapped the capital markets twice in its history when facing bankruptcy, "and both deals presented investors with tremendous opportunities to make big money," he said.

U.S. registered follow-on offerings total 278 this year, with some companies like Redwood Trust(RWT Quote) and FBR Asset Investment Trust(FB Quote) completing more than one. That compares to 150 in the same period last year, according to Dealogic.

So far, those offerings have yielded an average return of 3%, which is consistent with Ritter's theory that stocks rise in the first couple of quarters after the stock issuance. Still, Ritter and Loughran say the honeymoon won't last forever, and many of these companies are likely to face relatively disappointing returns over the next few years.

"This is an opportunity to rethink your investment," Loughran said.