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Resident trader
Of speculation, share placements and sophisticated investors
Will Kraa, November 28, 2007
I have an interesting little company I want to tell you about and when I’ve finished I’m sure you will want to buy some. In fact when I told one of my friends about it he thanked me for the tip and told me he had a very nice bridge he could sell me with a special discount to get it carted up from Sydney. And the other thing I’d like to talk about is a long-held gripe I have.
So, let’s get the gripe out of the way first. It often happens that small companies (and as you will see below, they are my favourites) need to raise funds for acquisitions or to carry out further exploration etc. and basically there are two main ways of doing this. They can ask for a loan from a bank or from investors or they can sell more shares.
So what is best for the shareholders? It is usually considered that placing more shares dilutes the value of the shareholders equity. That may not be true if the company acquires equivalent value in assets of one kind or another to offset the funds provided by shareholders. But there is one thing that really annoys me about these placements and it does dilute the value of shareholders’ assets.
That is the practice of many companies to place the shares with institutions and “sophisticated investors” usually at a substantial discount to the current price. Now I don’t mind the institutions getting something at a discount. We all know the poor things need all the help they can get in trying to outperform the general market for the sake of the ordinary folk who give those who run these funds a fixed percentage fee for mostly doing a mediocre job (with a few noteable exceptions).
Now I don’t know where they find these “sophisticated investors” (I have my suspicions) but I do know I have never been asked if I qualify. These folk are rich people and the reason they get these discounted shares is because of what seems to me a stupid rule imposed by the authorities. Of course this is to protect us ordinary folk from ourselves and our well-known tendencies to throw our funds at any risky project. Now it is true that some folk (as you will see later) do throw money at very risky companies but it seems strange to me that ordinary shareholders are prevented from acquiring more of that which they have already decided is a suitable investment.
The rule is this. If companies want to issue more shares to ordinary investors (even those who already own shares in the company) they must provide a prospectus. And here is the problem – preparing a prospectus is a costly and time consuming exercise. So companies avoid this expense by selling the shares to these “sophisticated investors” who obviously are so wise they do not need to be protected from their own stupidity for wanting more shares in their own company.
But you may say, I have at times been offered shares in a company I own without a prospectus. You will no doubt have noticed that you were in these instances offered no more than $5,000 worth of shares since that is the maximum amount of additional money you can be trusted to invest wisely if you are not rich enough to be considered “sophisticated”.
Now I can understand that when a company is floated there needs to be a prospectus. But when I have decided to invest in an existing company it could be assumed that I have done whatever is needed to make this decision. Am I not qualified then to make a decision to invest more in the company if an offer is made to me? This “protection” from my own assumed stupidity does come at a cost over which I have no say. The “sophisticated investors” are able to buy the shares at a discount and this does dilute the value of my holding. Sometimes the share price drifts down to the discounted price (people possibly assume that must be the correct price, or is it that the “sophisticated investors” decide to cash in their windfall?).
In my opinion it seems the only fair rule is that companies must offer any additional shares first to the existing shareholders, then to others if there are some left over. Existing shareholders have decided to support the company, are affected by any dilution there may be and should be the first to be given opportunity to buy shares in a placement to raise funds. But who is that makes the rules? Enough said.
Now I’m going to tell you about that little company my friend did not appreciate. I was looking through some charts the other day when my wife noticed the chart shown below. As you can see it shot up from 0.5 cents to nearly 3 cents and is still to this day trading above 3 cents. She asked me if it was one I had bought and I told her I had not.
At 3 cents the market capitilisation is over $15,000,000. The people who are paying this sort of money for it obviously know something I don’t know. There seems to be no other explanation. The day the price started shooting up was after the ASX had asked the company why they should not be suspended and gave them 3 months to fix things. The company had cash in the bank of some $400,000 and no other assets. No business, nothing. The ASX does not like that, since listing is not for those who simply operate a savings account.
The company responded by saying that it was actually looking for a business and had some ideas in mind. It was about to give shareholders the right to buy options at $0.001 (exercisable at $0.01 within 18 months) at the rate of one option for every share held. This would raise about $500,000 of which over $100,000 would be spent in raising this money. Now in view of what I wrote about at the beginning, you might ask if this one was only for the “sophisticated” investors but in fact the company did supply a prospectus. Maybe the sophisticated ones were not interested and probably it is not so hard to write a prospectus for a company that has no business. The main thing that has to be done is warn investors that there is no busines, there may never be a business, you may not be able sell the options, if it is possible to buy a business it may fail and if it is possible to buy a business there will have to be further capital raising (which may not be possible) and that will seriously dilute the value of the options, etc.
In its prospectus the company fairly warned potential investors of all the possible risks and that in the end it might all come to nothing. The directors did what they are expected to do and no doubt are making every effort to create value for the shareholders. What I don’t understand is why people want to invest in this so badly as to raise the price to such an extent. As an example I noticed one bid for 1,000,000 shares at 3.1 cents, which amount to $31,000, to buy a very small portion (less than 0.2%) of about $800,000 plus the vague hope that there might be a functioning business someday.
If the options were exercised at 1 cent one day, that by itself would seriously dilute the value of the shares bought at over 3 cents and the capital raising necessary to buy a serious business would require vastly more shares to be issued so that the original shares would finish up being an insignificant portion of the business. This seems to me the ultimate in pure speculation.
However, I do buy what might be considered speculative shares which might seem to be like the one above. I have previously explained a couple of these trades and the method I use to find them. Also in the ‘Your 2 cents’ there is an answer to a question where I explain more of how I look for them with AmiBroker. So here is another case where I used this method.
Every day I download 20 minute delayed intraday data usually starting at 11:20 am and use the ‘Quick market review’ function of AmiBroker to find shares which have jumped up in price at higher than usual volume. It is also possible to write an exploration for AmiBroker which will save time by looking specifically for these shares. When I use one of them it only takes a few minutes to compile a small list and to set things up so that simply highlighting a share in the list brings up the chart for instant appraisal.
Notice in the Quick Review panel that KSX is there on the highlighted line. This scan was done on the end of day data but on 15/06/07 it would have been done earlier in the day and the price would have been lower at that time of the day. I noticed the good increase in price accompanied by good volume and in AmiBroker it is simply a matter of double clicking on the line of interest to bring up the chart.
On the chart for Karmelsonix Ltd (KSX) price and volume are starting to rise in early June as the share price emerges from a long period of low volume and lackluster trading in a range of low prices. This is the kind of pattern I like to see as it usually means some good things are starting to happen and the market is taking notice. I also need to see enough volume so that at the price there is sufficient turnover value to make it possible to buy or sell without the danger of being stuck with shares and few buyers.
The chart met my criteria for the sort of trading pattern I was looking for but that was not sufficient for me to buy it. I am not very interested in pure speculation as in the RCH trading mentioned before. There needs to be some good news which is likely to lead to a rerating of the share price before I will be interested in buying. In the case of KSX it was the good results they were having with non-invasive breathing monitoring equipment for patients with asthma and similar breathing problems.
By the time I did my scan and checked out what was causing the price rise it had gone up to $0.06 and as you can see by the end of the day had gone up to $0.07, a 32% increase for the day. It is always hard to be willing to buy shares that have already risen substantially since it seems they surely cannot go up even more. This is particularly so for shares that show an almost vertical chart. There was a time when I found it hard to do these trades but as I became more used to it I realized that very few of these trades became unprofitable and that the strategy itself was very profitable. It makes me a lot of money.
It is necessary to develop confidence in the strategy you are following since that helps you to put it into practice without hesitating. With stocks that move so fast it is necessary to take action as soon as the signal is given.
In this case, taking into consideration the kind of business the company was engaged in and the fact that it was moving into a phase where it could develop into a profitable business, I decided it was a suitable investment for my SMSF. I was able to buy 200,000 KSX at $0.06 on 15/06/07 and by 26/07/07 the price had reached a high of $0.285. While I had bought these shares as an investment for my SMSF, it is also necessary to guard against undue risk and so when prices became volatile and moved below the closing prices of the previous low I decided the risk was no longer acceptable and sold at $0.17 on 21/09/07.
As far as risk management is concerned the total value of the entire initial investment is much less than 2% of the capital in my SMSF. This means that if the investment had gone completely wrong it would still not have been outside the level of risk suitable for this account. If I had taken more risk by buying more then of course the return would have been spectacular but a SMSF is not a suitable vehicle for too much risk.
If I had been trading these shares I would have adopted a different stop loss strategy and got out at a slightly higher price. Since I sold the shares the price has been volatile, daily turnover has declined, and at the time of writing is still not much changed from the price where I sold.
The shares that come up on my daily scans are usually more suitable for trading but from time to time there are ones which are in a business that over time could develop into something really good and I will buy them for my SMSF. This strategy is not suitable for everyone and if you intend to use it to find shares to buy for your SMSF you must get advice and be sure it is a suitable investment for your fund.
As far as RCH is concerned, it is tradeable, some people have no doubt made a lot of money from it, but it is definitely not for your SMSF. Even the directors when asked by the ASX on Friday to explain the price moves could give no reason for it. It is not the sort of thing I would like to trade and I still don’t have any idea what drives people to want to pay those prices for it. Does that make me a “sophisticated investor”?
Calculations
Cost of 200,000 KSX @ $.06 is $12,000
Sale proceeds 200,000 x $0.17 = $34,000.
Gross profit $34,000 - $12,000 = $22,000
Brokerage for the two transactions is $66.
Net profit $22,000 - $66 = $21,934.
Return on equity over the 3 months of the investment is 183%.
Note: KSXOA are options issued by the company and would have given an even better return but you have to be careful there is enough continuing liquidity to buy and sell them.
More articles from this edition of CompareShares:
Investing: Overseas shares not so taxing
Investing: Of speculation, share placements and sophisticated investors
Stocks: Stock picks for the long haul: Service Stream and Redflex Holdings
Trading: The ultimate guide to trading shares - part 2
Analyst report: When funds fall over
Economics: Mining boom teeters
Stocks: Stock to watch - VDM Group
Smart Investing: ATO reviews use of instalment warrants in SMSFs
Expert Panel: Pairs trading - maximise returns from share price divergence
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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