Last month I asked Zach from Zachstocks.com to give us an insight into IPO's. Today he's going to teach us the in's and out's of Secondary Offerings.

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Besides Initial Public Offerings (IPOs), the fund that I manage is also very involved in secondary offerings. The concept of secondary offerings may not be very familiar to most individual investors, but it actually may have more of an effect on the price of stocks they participate in than originally thought.

A secondary offering is simply an additional issuance of stock to the market. The additional stock may be considered primary shares (shares actually being sold by the company itself) or the stock may come from large existing holders of the stock. While the net result is often the same (additional shares in the public float), the resulting fluctuations in the underlying price can vary drastically and often depends on which type of stock is being offered.

While every case should be analyzed individually, it is widely accepted that primary shares are more constructive to a company and its stock. The reason is that the actual company is receiving the majority of the capital and can put it into use within the context of the business. One industry that has been very active in issuing additional primary shares this year is the shipping industry. Zachstocks has covered companies such as Diana Shipping Inc. (DSX) and Euroseas Ltd. (ESEA) that have come to market from time to time to raise additional capital. This capital is put to work to buy new vessels which increase the profitability of the company over the long term. While the sale is often initially dilutive to current shareholders in regard to the technical book value per share, if management can explain how the additional capital will be put to work profitably, the shares often rally after a deal is priced.

On the other side of the coin is a secondary offering that is simply providing existing shareholders an easy exit. Ironically, while this type of trade has virtually no economic effect on the underlying company, this type of secondary offering can be damaging to existing shareholders. The reason revolves both around the supply/demand equation as well as hinging upon the element of trust or confidence which is paramount in the trading of securities. If I as an investor know that one of the founding members of the firm I am holding has decided to liquidate his position, it immediately makes me suspicious. Questions such as why this party would be selling some or all of his position can result in a lower multiple as the perceived risk in the stock is higher.

At the same time, basic economics will tell you that when there is excess supply (imagine a large block of stock hitting the market) and demand is not strong enough to soak up that supply (who is going to buy this insiders 10 million shares?) then the natural result is lower prices. While the price may often bounce back as nothing has fundamentally changed within the company, it is uncanny how many times an insider will sell prior to a large decline in the stock. It may be that he knew more about the business environment than the general public and so his expertise allowed him to exit the stock at an attractive time. This does not necessarily mean that there is insider trading occurring, but more likely that his knowledge of the entire industry or economy leads him to make a wise selling decision.

So while secondary offerings may not rise to the top of applicable data when choosing an investment, one who is holding a stock long-term should pay attention when an offering of this type is announced. While there are some private transactions that never hit the news wires (I field calls from underwriters about these on a weekly basis), many of the larger offerings actually hit news services and can be found on ino.com, or any other capable news feed. If one of the stocks that you are involved in issues a secondary offering, look up the prospectus which is free on the company’s website and see who is selling the stock and if it is the company, see what they are going to do with the capital. You may find that the capital is being put to wise use and that may lead you to increase your position. On the other hand, if the company’s founder is selling his last remaining shares, consider yourself warned!

Zachary D. Scheidt, CFA

Zachstocks.com