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Op-Ed: Are Secondaries Priced Right?


Current versus future perceptions are key to value.

Editor's Note: James Kostohryz was formerly the head of international investments for a major Brazilian investment bank.

When Minyan Peter talks, I listen. His expertise is unparalleled in this forum, and his writings (see Three Reasons Why Investing in Common Stock May Be a Terrible Idea) are always packed with wisdom.

Fortunately for me, I don't believe we have a disagreement regarding the principles that should be applied to analyze the impacts of equity issuance (see my article from yesterday, Op-Ed: Are Equity Offerings Bad for the Market?).

Possibly, there's only a difference in our assessments regarding the attractiveness of the values at which these deals are being priced.

On that point, I'd only make the following general observations. Again, I think that most of this will be consistent with the views expressed by Minyan Peter.

In my view, up until very recently, many stocks weren't only pricing in the risk of insolvency; they were pricing in a virtual certainty that due to systemic financial stress, it would be impossible to raise capital in private-capital markets. This was a "double whammy."

As the systemic stress in the financial system has subsided, and the functionality of capital markets have been reestablished, opening the possibility of raising capital, the latter risk factor cited above has been erased.

Thus, once you reestablish the option of raising capital, the value of a stock in a financial distressed condition will tend to react. As Minyan Peter points out, this isn't surprising, and is appropriate. But how much of a pop is warranted?

To some, it might seem fairer to investors in secondaries of distressed stocks that they be able to capture the gains of "saving" the company. However, capital markets, being what they are, will tend to arbitrage those gains away to the point where secondary investors will garner returns merely ample enough to satisfy a "reasonable" discount great, but no greater than that. This type of behavior would be predicted by economic theory. Excess, or "abnormal" returns, will be arbitraged away, prior to the secondary offering.

Thus, economic theory suggests that under the conditions I've outlined (moving from a situation where it's impossible to raise capital, to one where a capital raise is imminent), the prices of distressed stocks will rise.

Now, with respect to Minyan Peter's point: Have they risen too far? Are the investors in secondary issues paying too much? Are the post-dilution values of these stocks too high, given their future earnings prospects? Are we, as Minyan Peter suggests, "celebrating survival to excess?"

Here, reasonable people can disagree. And evidently do.

This is a question of valuation. And I believe that Minyan Peter and I will agree that this can truly only be answered on a case-by-case basis by way of a detailed analysis of each stock.

However, on my analysis, in the majority of cases thus far, I believe investors have been getting a good deal. Indeed, I think they've been getting a better deal than economic theory would suggest - i.e., I think abnormal returns are still in evidence in most of these cases.

However, due to the enormous uncertainties associated with an investment under current circumstances where the future is so unclear -- and that's particularly true in the case of banks -- unusually high "discount rates" are at least understandable.

My detailed valuation analyses suggest the prices being reflected in most of the deals are discounting a macroeconomic scenario that, on average, is something in between what the government laid out in SCAP (fairly sanguine) and Roubini-type scenarios (doomsday). Or a more accurate way of describing it is that stocks aren't pricing in an either/or scenario. They're reflecting a distribution of odds that various possible scenarios could materialize.
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No positions in stocks mentioned.

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