Why Your Stocks Are Getting Hammered

During tough times, you depend on company management to keep your share prices from falling. Lately, however, managers have taken actions that hurt current shareholders. And unfortunately, there's not much you can do about it.

The credit crunch has led many companies to offer new shares to investors to raise capital, often at bargain prices. According to The Wall Street Journal, U.S. companies have issued more than $44 billion in equity so far this year. Although managers insist their actions are necessary to ensure the survival of their companies, current shareholders end up suffering twice: Their share of the company gets watered down, and their potential for profits, if the company recovers, becomes smaller.

Stock dilution and you
Secondary offerings of equity have become widespread. Last August, Bank of America (NYSE: BAC  ) made a $2 billion investment in Countrywide Financial, essentially buying shares at a 20% discount to Countrywide's then-prevailing stock price. Similarly, Washington Mutual (NYSE: WM  ) obtained $7 billion from a private equity group at a 25% discount to what shares traded for at the time.

The core of the problem comes from stock dilution. By issuing shares for less than the current market price, the intrinsic value per share of the company falls. For instance, if a company with 1 million shares outstanding is fairly priced at $10 per share, and it issues another 1 million shares for $8, then the fair value of the stock falls to $9 -- theoretically costing current shareholders 10% of their investment.

Bad timing
Although banks and other financial institutions hit hard by the subprime crisis have had high-profile secondary offerings lately, the problem isn't limited to the financial sector. Chesapeake Energy (NYSE: CHK  ) , for instance, has routinely issued new shares, including an offering just last month priced at $45.75 -- more than 16% below last Friday's closing price.

Similarly, last December, North American Palladium raised $86 million in an equity unit offering that valued shares at just $4. By late February, improving prospects for palladium had pushed the share price above $9. The company probably could have gotten a much better deal simply by waiting a few months.

When issuing shares makes sense
Of course, selling new shares to raise capital isn't always a bad move for shareholders. Sometimes, companies take advantage of temporarily high stock prices. For instance, last October, Wynn Resorts (Nasdaq: WYNN  ) collected $154 per share in a secondary offering. The move turned out to be perfectly timed, as the stock fell below $100 within the next three months. Just as discount sales dilute existing shareholders, the cash from the high-priced offering probably cushioned the blow for longtime Wynn investors.

When Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) issued its B shares in 1996, its stock price had doubled in the preceding two years. In the prospectus, managers Warren Buffett and Charlie Munger specifically told investors that they "believe that Berkshire's [stock] is not undervalued" and that neither of them "would currently buy Berkshire shares at [the current] price, nor would they recommend that their families or friends do so." That didn't stop the price from more than doubling again by 1998.

Still, many companies are less lucky with their timing. Citigroup (NYSE: C  ) managed to issue new equity units that involved selling shares for as much as $37. Yet while that's above where the stock was trading, it's far below the $50 level where Citigroup was doing share buybacks in 2005-06. It's likely that many other companies will look back at share buybacks they did during the last bull market as having been similarly bad investments, especially if liquidity problems continue for some time.

When corporate executives face challenging situations, they're supposed to put the interests of shareholders first. Issuing new shares at fire-sale prices, however, forces existing shareholders to bear the cost of the mistakes those executives have made. If you see your managers acting against your best interest, it's definitely worth considering voting with your feet and getting out before you see any further damage to share prices.

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