The Drama Of Nil-Paid Rights Trading

Foreword from ShareInvestor

This article “The Drama Of Nil-Paid Rights Trading” by Cai HaoXiang was first published in The Business Times on 08 Aug 2016 and is reproduced in this blog in its entirety.

Sheer volatility marks the trading of nil-paid rights, and traders have to be aware of what drives the value of these options

Last week, we examined the first part of the rights issue process of commodities trader Noble Group using the analogy of mothers and daughters.

We discussed how given the negative sentiment around Noble’s accounting, the price to net tangible asset (NTA) ratio provided little practical guide to how low Noble shares would fall, once it announced its intention to raise capital from investors.

We also examined how on June 28, when Noble shares started trading ex-rights, what seemed like a fall was actually a rise when the theoretical ex-rights price (TERP) was taken into account.

This week, we run through the most exciting part of the rights issue process where trading is concerned.

This is when Noble’s nil-paid rights, or options to purchase new shares for S$0.11, began trading on July 5.

We called these rights “daughters”, because they were split off from the original “mother shares” to become traded on their own for around a week.

There were opportunities to make fantastic returns of up to 50 per cent in one day, as well as devastating losses of 50 per cent over a few days.

After the trading ends, investors who end up owning these daughters will have the choice of paying another S$0.11 per daughter to subscribe for the rights, converting the daughters into new “mother shares”.

Last week, Noble officially went from 6.5 billion shares issued before the rights issue, to 13 billion shares issued, thus completing the rights issue process.

A Fundamental Detour

Before we dive into the trading of nil-paid rights proper, we revisit our fundamental calculations.

In Noble’s case, we had the NTA to go by. Last week, we used Noble’s NTA per share before it embarked on its rights issue.

Yet, NTA will increase after money comes into Noble’s coffers as investors pay up to subscribe for new shares.

So another way to determine the value of Noble was to calculate its NTA after its new shares are issued and listed.

Given that Noble had roughly US$3 billion of NTA and raised another US$505 million, we can work out its new NTA per share, using a conversion rate of S$1.35 per US dollar.

Noble’s new NTA of US$3.5 billion, divided by 13 billion shares, is around S$0.367 a share.

Now, you might think that a lower discount to NTA is now justified, given the influx of “good money”, or cash, after its rights issue.

Yet, don’t forget a fifth of that new money will be used to pay off debt, while four-fifths of the money will be used for its day-to-day trading needs.

If investors think that good money is being thrown after a bad business, they would not regard the influx of cash as a good thing.

Alternatively, if the cash enables Noble to become financially stronger and regain the support of bankers, then the current deep discount to Noble’s assets, implying potential bankruptcy, will ease.

In any case, it is worth noting that the rights issue offered existing investors a chance to buy new shares at S$0.11 a share.

Eleven cents a share works out to 0.3 time Noble’s post-fundraising NTA per share, or an implied valuation of about US$1 billion.

Of course, new shares are priced at deeply discounted levels to attract shareholders to bite at supposedly undervalued prices. They do not mean Noble is worth just US$1 billion.

For what it’s worth, though, Iceberg Research, the little-known firm that played a key role in destroying market confidence in Noble with its allegations of improper financial accounting, had valued Noble’s equity at US$410 million last year. That was at a time when Noble had US$5 billion of equity on its books.

Iceberg arrived at the valuation after forecasting some US$4.65 billion worth of impairments, including discounting a significant chunk of its US$5.8 billion of fair value gains on commodity contracts and derivative instruments then as at September 2014.

If Noble ever trades at S$0.11 a share, it would imply that Iceberg’s doomsday valuation of US$410 million had almost come true: US$1 billion at the new share price, minus the US$505 million it raised.

Whatever Noble’s valuation should be, S$0.11 per share, or 0.3 time post-fundraising NTA, provides a backstop to its value somewhat.

If 0.3 time post-fundraising NTA of S$0.11 per share (where nil-paid rights become worthless) provides a support level, one might think an intuitive resistance level could be 0.5 time post-fundraising NTA, or around S$0.18 a share (S$0.07 per nil-paid right).

Noble has not traded anywhere near 0.5 time its NTA ever since it announced its rights issue on June 3, so these ranges seemed reasonable.

Yet, 0.3-0.5 time NTA provides an incredibly wide range for nil-paid rights to fluctuate between, from zilch all the way to seven cents.

July 5: “Daughters” Start Trading

Trading of Noble’s daughters, the nil-paid rights, commenced on July 5.

In Noble’s case, the daughters were labelled “Noble R” on SGX’s website. To reiterate, if you buy these nil-paid rights off the market, you are essentially acquiring the opportunity, but not the obligation, to buy a Noble share, after paying another S$0.11.

So if you spent S$0.07 buying a nil-paid right, and you eventually exercised your right to buy a Noble share, your total cost per share will be S$0.07 + S$0.11 = S$0.18.

Immense volatility can usually be expected in the nil-paid rights shares. This means the swings in their prices – in percentage terms, not absolute terms – will be far more extreme than those in the mother share.

For example, if the Noble mother share moves from S$0.18 to S$0.20, it would have gone up by 11.1 per cent.

But the nil-paid rights would theoretically jump from S$0.07 to S$0.09, a 29 per cent gain.

Given the opportunity for more extreme price gains, trading activity typically moves from the mother share to the rights entitlements once the latter begin trading.

Essentially, buyers and sellers of nil-paid rights are trying to guess where the mother share price will be, and trade accordingly.

Another reason why people trade these rights instead of mother shares is that these options go for a far lower price, which make them easier to trade, psychologically speaking.

In Noble’s case, the rights began trading at around S$0.07, compared to the “mother share” that was trading at around S$0.18.

This meant you could acquire the right to buy 100,000 Noble shares for just S$7,000. But you don’t just pay S$7,000 if you really want those shares. You would have to eventually pay another S$11,000 to turn your rights into new shares.

Many people who buy 100,000 rights don’t have the money to subscribe to the rights to get new shares, or are unwilling to do so.

Hence their intention is to sell it to someone else.

Time Value

The most volatility usually occurs at the beginning of the nil-paid rights trading period.

This is because these options theoretically have a “time value”.

Buy them earlier, and you will have more control over when to let go. There is more time for prices to move your way.

If you buy the nil-paid rights on the last day of their trading, your ability to capitalise on future price movements in the mother share is limited. If you don’t sell them, you will likely end up having to accept those rights or let those rights expire worthless.

If you don’t have enough cash to accept the rights, you have made a horrendous mistake.

Hence traders have to be careful not to bite more than they can chew. The closer it is to the end of the trading period of the rights entitlements, the more wary they should be of buying more of them.

Trading The Nil-Paids

The first point to note on the trading of nil-paid rights might sound simple. That is to take note of when they start trading, and remember how many nil-paid rights you are entitled to given your holdings on the book closure date.

The reason is because you might only be officially informed of how much rights you have through an offer document in the mailbox quite a few days after the rights start trading.

And given the time value of these options, if you plan on selling them, you need to be alert right at the beginning when they start trading.

(In fact, for the sake of fairness for those who do not follow the news that closely, investors should arguably be posted these documents at least a few days before the nil-paid rights start trading.)

Interestingly, the price of the nil-paid rights themselves can deviate from the theoretical price otherwise implied by the mother share.

At the end of the first day of nil-paid rights trading on July 5, the mother share had soared to S$0.205 (0.56 time post-rights NTA). This would imply a nil-paid rights price of S$0.095.

But the rights were trading at S$0.105, a full cent above what one would think.

Their trading had taken on a life of its own. Traders who bought at S$0.105 were betting that the mother share might soar to say, S$0.25 (above two-thirds NTA), with a theoretical rights price of S$0.14 and a 33 per cent return.

The first day of nil-paid rights trading thus was a blast for longs. Rights went from S$0.07 to S$0.105, a 50 per cent return in the space of a trading day.

Unfortunately, persistent bulls were caught with their pants down. The first day marked the top. Within the next three trading days, Noble mother shares had plunged to S$0.164 by the close of July 11, a 20 per cent decrease from the closing price of S$0.205 on July 5.

The rights, meanwhile, plummeted to S$0.049 on July 11, or a whopping 53 per cent decrease from S$0.105 on July 5.

On July 11, you would think the entitlements would trade at its theoretical nil-paid rights price of S$0.054 (S$0.164 – S$0.11).

But the fact that they traded 0.5 cent lower, at S$0.049 suggests that traders were betting for Noble mother shares to fall further to around S$0.16, which was near the historic ex-rights intraday low of S$0.159 on June 28, discussed in our previous piece.

In fact, the rights would go on to hit a low of S$0.044 on July 12, implying a mother share price of S$0.154 (0.42 time NTA), close to the historic TERP low of S$0.155 on June 27.

The key to understanding the disconnect between the nil-paid right “daughters” and the mother shares is that stock markets operate on expectations.

If people expect the mothers to soar, they would bid up the daughters beyond what they are worth, given the high percentage gains they can make.

Similarly, if they expect the mothers to plunge, traders would dump the daughters such that they will trade below what they are worth theoretically, considering the mother’s price.

There was no arbitrage profit to be made immediately. Even if you buy a discounted daughter, the mother might go lower in the weeks it takes for the daughters to be converted into new mothers, and for the new mothers to start trading.

What didn’t help was how some Noble shareholders, including Noble Holdings Limited (a discretionary trust which has beneficiaries that include the children of Noble founder Richard Elman), were selling a substantial number of rights to raise cash to subscribe for new shares.

The practice is sometimes called tail-swallowing. This is a way to avoid forking out extra cash for rights issues. You sell some of your nil-paid rights so you can afford to buy the new shares on offer.

The lesson from Noble’s nil-paid rights trading is this: When trading something as volatile as nil-paid rights, which can be up 50 per cent one day and down 50 per cent the other, one has to move very quickly to cut losses or take profits, for the tide can quickly turn.

The Post-Issue Plunge

On Aug 4, Noble’s new 6.5 billion shares began trading.

Two days before the new shares were due to be credited, the counter suffered another bout of short-selling before recovering towards the end of the week. From Tuesday to Friday, over 1.3 billion shares were traded. Prices crashed below the S$0.155 support level discussed earlier to a low of S$0.122 on Wednesday, before recovering to close at S$0.154 on Friday.

In hindsight, even those who bought nil-paid rights at a low point would have been better off staying away and buying the mother share at last week’s prices.

It remains to be seen if the stock can find a bottom. This will depend on attempts to improve the firm’s operational cashflow in the months ahead, and how much cash the company can raise by selling its US energy unit. For short sellers, there is an upside risk in the coming weeks if Noble reports better results than expected.

In the meantime, Noble remains the playground of traders, and a cautionary tale on the volatility of stocks with shaky fundamentals.