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Big corporate borrowers can bring shareholders big profits. As companies seek funds to weather the market downturn, Timon Day considers the signs that distinguish stocks likely to reward investors

Bradford & Bingley might have been the latest company to announce a rights issue but it sure won’t be the last. UK PLC’s net debt-to-equity ratio is at a 20-year high but many banks want their money back

Analysts expect almost £30 billion to be raised this year by 50 to 60 companies. Though generally not considered a good, thing many companies that raise money see their shares outperform over a two-year period.

For the past six years, the name of the game was making balance sheets ‘efficient’ by borrowing more to gear up and buy back shares. This year, the tide has turned big time. Finance directors are scurrying to curry favour with their bankers, particularly if they are not with better-capitalised banks such as HSBC or Standard Chartered.

Morgan Stanley points out that the cost of equity has fallen to its lowest level, relative to debt, since 2001, which together with many banks’ balance sheet weakness means companies are going the rights route.

Big debts are bad news, especially if interest payments are anywhere near just twice covered by profits or heading in that direction.

Luckily for debt-ridden companies, most big shareholders are flush with cash. Even with the £22 billion-worth of rights issues already announced in the UK this year, and £135 billion raised by financial companies worldwide, the balance between equity issued and buybacks announced is close to zero, says Ian Scott, equity strategist at Lehman Brothers.

Furthermore, the extraordinary amount of shares cancelled and money paid to shareholders over the past five years means that investors have amassed huge portfolios of money market funds and bank deposits.

So Scott reckons there is no problem funding the rights issues and medium-term prospects for equities are undimmed.

Less sure is Charlotte Swing, the MS analyst who has been pumping out research on re-equitisation and the implications of rights issues. She says: ‘Although institutional cash holdings are high, many investors will still need to sell to buy in our opinion. History is of little use in offering suggestions as to where these sales will come from.’

Small research boutique Hardman & Co is positively gloomy. It reckons the cost of raising capital is becoming prohibitive. Investment banks and brokers are whetting their appetites: underwriting the Bradford & Bingley rights issue has almost doubled in a fortnight to 3.5%.

‘This will force those in need of cash to other routes, such as the sale of non-core subsidiaries, private equity and for sub-£100 million companies ‘pipe’ style equity call-offs that are starting to attract interest in the UK, following some successful applications in West Coast USA,’ says Hardman.

Its dire warning is that even the private equity and pipe markets may become sated before long and of interest only to the desperate. ‘Meanwhile any company with negative cashflow and inadequate banking facilities and with loan-to-value banking covenants whose security could be shaken by further property write-downs, had better do something more than keep its fingers crossed,’ says Hardman.

Aerospace and others riding high

Companies in growth sectors such as aerospace are pretty relaxed. ‘With over three times interest cover, probably rising to four this year, we are not facing any problems,’ says Kim Ward, chief executive of Hampson Industries.

Hampson had little trouble raising the $253 million needed to buy Odyssey Industries and Global Tooling Systems in the US last week by tapping investors through a placing. Its gearing is 67% but should fall fast this year as profits are forecast to jump by half. ‘We want to keep gearing high as it’s cheaper to have debt than raise more capital,’ says Ward.

Composite materials maker and spare parts supplier Umeco is also unfazed. Net debt rose by £5 million to £58 million but gearing is a modest 35% and interest cover is high. ‘We’ve got no problems at all,’ says chief exec Clive Snowdon. ‘Luckily we bank at Lloyds TSB and it is happy to lend us more money if we need it.’

The best bet is that there is enough cash for the early birds but it might prove tougher by the year end. Stuart Fowler, senior equities fund manager at Axa Investment Managers, says there is still a lot of cash from big takeovers and dividend payments that has not been spent but in six months time it ‘could be a different story.’

The rights surge has been led by Royal Bank of Scotland raising £12 billion followed by HBOS with its £4 billion cash call. This makes Bradford & Bingley’s £400 million look chicken-feed. At least we were spared one from Northern Rock which would have needed around £5 billion to stay afloat.

Unfortunately the government has had to pick up the bill instead, largely due to a misguided insider leaking NR’s plight to the BBC and causing a financial stampede.

‘There are going to be more fundraisings, that is certain,’ says John Duffield, chairman of New Star Asset Management. ‘We all know that Barclays is going to have to do something, but others will, too – house builders possibly. If we do see another big wave of rights issues that could have an impact on the market.’

Indeed, Britain’s big four builders all look like they will have to replenish their balance sheets if they are to both weather the sharp slump in home sales and buy up more land to position themselves for happier times.

Last week Barratt Developments shed another 10% as its shares fell to a 13-year low. Cazenove thinks the builder will have to raise £600 million in a deeply discounted rights issue. Taylor Wimpey might need to raise almost £900 million. Persimmon and Galliford Try will also need more cash.

Analyst Anthony Codling says land writedowns and office closures may not be enough to stem losses of indebted builders, since interest costs would eventually exceed any profit from home sales. ‘With cashflows in ragged retreat there is an increasing chance of capital raising in the coming months.’ says Codling. Barratt has £1.5 billion debt followed by Taylor Wimpey with £1 billion.

The cash-strapped chart

Broker Collins Stewart has drawn up a list of 40 companies it reckons will need more money and/or to cut their dividends to conserve cash. (see above).

Its new-fangled ‘fixed-charge coverometer’ looks at the sensitivity of cyclicals financial health against a deterioration in the economy. It looks at the cashflow of UK companies and crucially which companies have negative working capital.

The list shows the companies that give CS the greatest reason for concern. Most on the list have weak interest charge cover, even before simulating the effects of an economic slowdown. The table also shows companies whose gearing becomes most stretched, and other metrics that might tip the balance, such as working capital and margin structure.

CS’s economic decline scenario is a 1% drop in sales, a 15% cut in profit margins and 10% more working capital need.

The hard-up 40 are dominated by house builders, retailers and pub companies, though there are plenty of media, transport, leisure and support service companies too.

Fears are strengthening that the UK will actually go into recession, which means negative economic growth for six months in a row. The government says the economy will grow by nearly 2% this year and next, but the IMF is less optimistic.

The best bet is that if the US goes into recession the UK will follow. The companies most at risk are those at the mercy of increasingly hard-up consumers. This means banks and financial institutions with big home mortgage books – particularly those with sub-prime mortgages – and too many personal loans.

Obviously, companies dependent on consumer spending are expecting a tough time – with a few exceptions. House prices are expected to fall by some 20%, which isn’t good news for builders or banks. Companies least at risk are those least dependent on the UK economy. They sell most of their products overseas to booming BRIC countries, or export them.

The amount of fundraising could prove decisive. If UK PLC wants over £30 billion re-financing from institutions the going might get tough. Investors prefer having money returned to them in the form of share buybacks and increased dividends, not taken away.

Their patience and purse strings will become strained if too much cash is demanded. This means if the number of rights issues is significantly more than expected the stock market could take a tumble as shareholders either refuse to stump up cash or sell stock to raise finance. We may be in uncharted waters by the year end.

However, historical data mined by Morgan Stanley shows share prices of companies that raise a large amount of cash relative to their market value tend to outperform strongly, while those that raise low amounts of cash underperform. Its key findings are:

• Stocks that underperformed by at least 50% ahead of the rights issue will always outperform on a subsequent two-year view.

• Stocks that use the cash raised to repair balance sheets tend to outperform, those that use it for acquisition or capex tend to underperform.

Charlotte Swing of MS points out that UK PLC balance sheets are not as strong as we think. Shareholders’ equity has fallen to a 20-year low at 8% of total assets. Gearing is less than it was in 2001 but still around 40% compared with 15% in 1987.

Equity funding has been more expensive than bank debt for most of this decade. Between 2003 and 2006 the gap in favour of debt was a massive 2.5%. This has now shrunk to 1% or less – a tipping point. When this last happened in 2000 it prompted an increase in rights issues. Imperial Energy is a good example. It dropped a planned debt issue two months ago and raised £300 million through a rights issue instead.

History lesson for investors

Looking at 115 rights issues since 1993 reveals the subsequent share price performance depends on the size of the cash call. Every stock that raised 50% or more of its market capitalisation rose in absolute terms over the next two years, with 80% outperforming the market and sector.

Indeed the median stock that raised cash equivalent to more than 75% of its market value outperformed the market by 45% over the next two years and its sector by 58%.

It was a different story for companies raising less than 25% of their market cap. They fell by 5% in absolute terms and underperformed the market by 20% and their sector by 7%.

The other interesting finding from MS was that stocks that underperformed the market by at least 50% in the 12 months ahead of the rights issue outperformed over the next two years.

However, shares that outperformed strongly ahead of a rights issue also did better afterwards but only for one year. On a two-year view they underperformed by an average of 25%.

The good news for investors looking at the long list of 40 companies drawn up by Collins Stewart is that this sort of company benefits most from a rights issue.

The MS research reveals that distressed companies needing cash to repair and strengthen their balance sheets did much better than those wanting to make acquisitions or fund capex.

Usually these companies, like the banks and builders this year, performed poorly ahead of the rights issue. Afterwards they greatly outperformed the market and their sector over the six, 12 and 24-month periods after the announcement.

So the best bet for cash-rich investors is to buy shares in companies that hold distressed rights issues, providing they raise more than 75% of their market capitalisations and have performed poorly in the previous year.

Don’t back companies whose shares have been performing well and are raising less than 25% of their market value to buy other companies or fund capex.

The corollary of the rights issue is the dividend payment. This is the other corporate health check. If you don’t have the cash you can’t pay a dividend. Morgan Stanley found that companies that held a rights issue but didn’t cut their dividend performed better than those that just cut the dividend. This suggests there is nothing more hateful to most investors big and small than a company stopping juicy dividend payments. So even if they have to fund the payments themselves through a cash call it is better than forgoing it completely.

A dividend cut on its own, that is no rights issue, is, however, usually positive news. The median stock outperformed the market by 14% in the year after a dividend reduction and by 20% after two years. The probability that a stock that cut its dividend would outperform the market in the next year was 59%.

Drilling further into the data shows that stocks that underperformed by less than 20%, outperformed the market by a similar percentage the following year. Stocks that underperformed by between 20% and 60% generally underperformed in the next 12 months and only modestly outperformed on a two-year view.

The best were those that underperformed by 60% or more. After the dividend cut announcement this sub-sector rocketed on average by 72%, with a 75% outperformance probability.

The other tip to make money is to buy shares in companies that cut their dividends by 90% or more. In the past 15 years, around a fifth of companies cutting dividends have slashed them by this amount. In the next two years their share prices outperformed on average by 48%.

The weakest subsequent performance came from stocks that cut their dividends by ‘just’ 70% to 90%.

Swing’s research shows the higher the dividend yield and the bigger the cut the better the share price performance over the next year.

A stock yielding 12% which is cut by over 90% usually outperforms the market by a massive 57% over the next twelve month.

Surprisingly the weakest performance comes from stocks trading on a dividend yield of 6% to 8% ahead of the dividend cut.

The problem with historical data is that history never precisely repeats itself. However, the discerning investor can no doubt decipher some of the logic driving these research results, most of which will remain as true over the next few years as over the past 15.