Companies offer additional equity in their business for many reasons. Strong companies, however, sell more of their shares to fund acquisitions and expansion. Sure, that means there will be more shares outstanding. But the money raised from such an offering is invested in productive enterprises that earn a return. And that return means higher revenue, cash flow, dividends and eventually a higher stock price.
Many investors, however, can’t see past the dilution part. To them, it’s always better when a company buys back its own stock because that theoretically means more earnings will be divided among fewer shares.
Because of investors’ shortsighted focus on dilution, a secondary offering almost always causes a selloff in shares of a company’s stock, regardless of how solid the underlying business is or what management says it plans to do with the proceeds. In fact, issuing companies’ share prices often fall below the secondary offering price.
A case in point is this week’s secondary offering by master limited partnership Teekay LNG Partners LP (NYSE: TGP), which owns ships that transport liquefied natural gas (LNG) worldwide. On Tuesday, the master limited partnership (MLP) announced it would offer an additional 4.6 million units to the public, an increase of 6.6 percent to its existing base.
Teekay’s unit price immediately dropped 4 percent in the aftermarket, eventually hitting a low just under $38 on Wednesday. And despite stabilizing later in the week, the unit price still trades below the official offer price of $38.43.
That’s an extraordinary shift in sentiment for an MLP that investors had previously favored because of its strong fundamentals. Teekay LNG’s distributable cash flow surged 51 percent in the second quarter from a year ago and jumped 10 percent from the first quarter. Distributable cash flow is the relevant measure of MLPs’ profits, while conventional earnings per share is both a meaningless and misleading measure.
Teekay has consistently deployed funds raised in this manner to grow its fleet of carriers, which remain in heavy demand to accommodate rising global LNG traffic. It’s also likely to have all the business it can handle in coming years, as Australia begins exporting LNG en masse from offshore projects such as Chevron’s (NYSE: CVX) Gorgon. And that’s not counting the prospective trade when North America’s shale gas riches are available to the global market once export facilities are finally constructed.
Given that record of success in deploying invested capital, one would logically expect Teekay units to rally on a stock issue. But many investors reflexively assume issuing equity is a negative, at least until the company proves it will be deployed effectively. And in a nervous market like this one, not even the strongest companies are immune from selling.
Investor reactions like this demonstrate why automatic stop losses are a bad idea for dividend-paying stocks. That’s because the downside following equity offerings is never permanent. Sooner or later, the unit price will recover as the company proves the money was well spent. For MLPs like Teekay, that usually happens following a dividend increase.
The company raised its payout by 7.1 percent effective with the May 14 payment. And with its strong second-quarter numbers–namely a solid 1.21-to-1 ratio of distributable cash flows to distributions–another hike in the dividend should be forthcoming.
Again, that’s a reason to buy, not sell. And it applies to any solid company that issues equity and is punished for it in the stock market. Put another way, you don’t have to actually participate in a secondary offering of a strong company to benefit. All you have to do is recognize the offer is a favorable development and buy shares as fearful investors run for the exits.
That’s the essence of value investing, which is the most reliable way to build wealth in stocks whether your objective is growth or dividends. And at a time when so many are following price momentum–selling falling stocks and buying rising ones–there’s rarely been a better time to use a value approach and line your pockets for years to come.