Value creation of free options offer an optical illusion

CHALKIE

OPINION: The board of Kingfish Ltd should have looked at winding the trust up rather giving shareholders a bonus share issue.

Back in the 1980s us Kiwis were foolish investors. In the go-go days of the 80s boom we gave our money to all the wrong sorts of people; from fast-talking entrepreneurs heading companies like Chase Corporation, Equiticorp and Euronational to companies with unproven business plans that were backing new farming ventures such as alpacas, sea-running salmon or possums.

And we used to run share prices up on such things as companies announcing bonus issues, discounted rights issues, or share splits, seemingly oblivious to the fact that tearing up share scrip into different-sized pieces of paper created no value.

Unfortunately, we seem destined to have learnt nothing from our mistakes.

The recent finance company collapse has shown New Zealanders continue to inappropriately back so-called wide boys. Rod Petricevic of Euronational and Bridgecorp fame has been a common factor in both generations' mistakes but there are lots of new names embroiled, including Mark Hotchin and Eric Watson, to whom it now seems stupid to have given our money.

The share price performance of GPG would suggest we have learned that such things as annual bonus issues are of no value. They certainly haven't helped the performance of this perennial dog.

One could conclude (somewhat prematurely) that us share investors have learnt some lessons and that those caught out were just those old folk who were cajoled by recycled-insurance- salesman-turned-financial- planners to invest in finance company debentures.

But no, examine the recent share price performance and the decision-making of Kingfish Ltd to see we are still mostly amateurs.

The attached graph shows that the discount to asset backing or net worth (calculated by deducting the liabilities from the assets and dividing that figure by the number of shares on issue) of the listed investment company is at a multi- year low - 9 per cent versus a typical 17-20 per cent over recent years.

The decline in the discount to NTA (net tangible asset backing) suggests the shares have suddenly become more fashionable. Why the sudden popularity of this company - has head fund manager Carmel Fisher rediscovered her stockpicking mojo? Is the board looking to wind the company up to return the full asset backing to shareholders?

No, it would appear the rerating has come about from the decision made in July to hand out free options to shareholders at the end of this month. Punters have piled into the shares because options are what they like best in life. And they are free, of course, and will be worth a reasonable amount of money when allotted to shareholders and listed.

Something for nothing. Investment magic! Or is it? Chalkie reckons the supposed value creation (the company makes no claims of value creation here, it is the market getting overexcited) is an optical illusion, and in reality the dividing up of company wealth between shares and option holders (who will be one and the same to start with) is as value accretive as the pointless bonus issues from GPG.

In fact, the more Chalkie thinks about it the more the "free" option issue seems worse than a harmless ripping up and redividing of share scrip. It destroys value long-term. The scheme will create value for the manager if the options get exercised and the fund (and, thus, management fee) are expanded but destroy value for shareholders in the process.

The giveaway takes the form of one option for every two shares to holders on the register at 30 August. The options have a 95 cent exercise price and can be cashed in a number of dates leading up to September 2012.

The first "cost" to shareholders comes in the form of a dilution of the NTA of Kingfish from $1.04 at last measure to $1.01 assuming the options are exercised in the future.

On a simple algebraic basis, punters piling into the shares to get entitlement to the options better hope they sell for more than 6 cents to make up for this dilution - plus a bit more to make up for the fact the share price has been pushed up ahead of the option giveaway.

Most importantly, history suggests that listed investment funds mostly trade at a substantial discount to calculated net worth - let's call it 20 per cent for the sake of a neat figure. This leads to a simple conclusion. If investors put $1 into such a company and try to sell shares the next day they will lose 20 cents.

The calculations get a bit complex when options are involved as these instruments may or may not become worth something. If they do become valuable by exercise date, it will be at the expense of the ordinary shares. It is best to ignore these complexities and go back to the powerful truth that every dollar put into a listed investment fund becomes worth 80 cents.

So to the extent the option issue encourages new money to be put into the company, it will destroy value.

If investors really want to put more money with Carmel Fisher they would be much better off placing the money into her unlisted trusts where there is no discount issue and a dollar put in tomorrow could be taken out a week later for pretty much the same amount.

If Chalkie had been on the Kingfish board when she popped the option idea into the monthly board pack he would have quipped "good try Carmel, now let's talk about ramping up the share buyback scheme ahead of the eventual winding up of the fund, that will create value for shareholders".

When Kingfish was formed there was good rationale behind the float. A listed company has the advantage of being a "closed-end" fund - investors can't ask to redeem their units or shares. This allows the manager to invest in large illiquid positions in promising small companies and not face the risk of being a forced seller under a rush of redemptions by unit holders in a shaky market.

This, in turn, allowed Kingfish to declare itself a long-term investor and not provide for capital gains tax on any wins. In contrast, the unlisted trust industry at the time had to provide for and pay such capital gains tax. The listed structure gave the fund a very powerful tax advantage over unlisted unit trusts.

With the introduction of the PIE regime in New Zealand all funds - listed or an unlisted - escape capital gains tax on New Zealand shares.

The tax advantage Kingfish once enjoyed has gone and therefore lessened the rationale for its existence.

Rather than looking to expand the fund via tricky options, Chalkie reckons it would be far more sensible to look at winding the fund up and offering keen Carmel Fisher fans units in her unlisted funds instead.

Chalkie is an anonymous columnist. The name is derived from the people who used to "chalk" up the share prices before the market went electronic.

- © Fairfax NZ News