Trading Rolls-Royce’s rights issue

Few brands in the world are as well-known as Rolls-Royce, a legacy of its long heritage in luxury cars. What is less widely known is that Rolls-Royce is now no longer involved in the automotive business, which was demerged from the group in 1973. Now the business is largely focused on the development and manufacturing of aero engines as well as providing aftermarket service.

Given that flying has taken a back seat in 2020 it is little surprise that the shares have had a terrible pandemic, collapsing from around 700p to a low of 101p last week. To shore up its finances the company recently announced a rights issue that will offer all shareholders the opportunity to participate in the company’s fundraising.

Personally, I think rights issues are much fairer than equity placings. In an equity placing it’s often the institutions that get the plum deals rather than shareholders. Back when Jet2 (JET2) – the former Dart Group – and JD Wetherspoon (JDW) raised capital this year I put in orders for both. I was expecting to be scaled back as is often the case in popular placings but in this case I received zero percent. Is that fair? I don’t think so. Nobody knew that I would be selling the stock for a quick profit aside from my broker – and I am sure many loyal shareholders wishing to buy discounted stock were also shut out of the placing.

With a rights issue, this is not the case. All shareholders at the ex-rights date are offered the opportunity to either buy more shares and stand their corner in the rights issue or sell their rights and receive the cash proceeds. This is different to an open offer whereby if the shareholder does not take up their entitlement, they receive nothing.

Rights issues are confusing for many traders and investors. This is because many believe the rights are like an equity placing which is discounted stock. But this is not true – the rights are an offer for shareholders to buy more stock or sell the rights and receive the cash proceeds. Rights issues can create a lot of volatility in the confusion and provide traders with opportunities both long and short. I have written more about rights issues on my website.

Chart 1 shows why I have never touched Rolls-Royce stock until recently. Why would anyone want to own this business as a private investor?

Although I am a trader, it is clear to me from a quick glance at the stock’s chart that the company was going nowhere soon. Despite the stock grinding higher in 2016 the company headwinds were well documented. The stock was also well off its highs with a lot of stale bulls to churn through.

Of all the companies listed on the stock market (there are around 2,000) is it not possible to find a better company than this? Personally, I prefer to deploy longer term funds into companies that are inefficiently priced where the private investor can gain an edge by doing his or her research. Companies such as Rolls-Royce are covered extensively by swarms of analysts. I also think larger companies can be higher risk too. The upside is smaller and if something does go wrong the downside is much higher. A member of my family is now 90 percent down on his Rolls-Royce shares. Every stock – no matter how big or prestigious – can fall heavily.

In my view, Rolls-Royce’s rights issue should have been announced much sooner. The company has been struggling for a while, but has justified the delay by saying it wanted to show the market it was doing its best to help itself by slashing costs and expenditures. Whilst this is a nice sentiment, the share price was much higher months ago and as a result of management’s mistake (granted, it is easy for me to say in hindsight) the dilution to shareholders is going to be much higher.

The proposed rights issue is to be fully underwritten in a 10 for 3 rights issue offer at 32p. Many private investors focus on the rights issue price, but until the stock trades ex-rights this does not come into play. Furthermore, it is like a stock that goes ex-dividend – the next day the stock will usually open down by the amount of the dividend (assuming the market is efficient). There is no free lunch here. Therefore, holding the stock cum rights in order to ‘benefit’ from the discounted rights is a mistake because it makes no difference (again, all things being equal).

Looking at Chart 2, we can see the volatility that has occurred since the announcement of the rights issue.

We can also that the stock tagged the 100-day exponential moving average (EMA) as resistance twice. When the stock rallied from 101p to around 250p in just a few days, the stock again tagged the 100-day EMA zone and began to collapse again. Identifying levels of support and resistance to trade from in advance of a trade is always a worthwhile use of a trader’s time.

I am watching for the stock to hit 100p before going long. It may not get there, but that is a clear level of support for the stock. Once the rump is placed we may see a rally in the stock as the uncertainty has been cleared. But if the rights issue is poorly taken up, it may also suggest that there is a lack of investor confidence in the company still. Two things are for certain here: Firstly, rights issues are not a gift of cheap stock that many people believe, and secondly: there will be plenty of opportunity for traders yet.

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