It has been a while since I have written journal-type blog post. I have had a list of blockchain projects and a few stocks to review – I still have a few more to do as well. However, I figured it was time to discuss a lesson I learned from the Sientra trade.
A few weeks ago, I was asked, “when do you exit a trade?”. That is the question that has hunted traders at night, at work, during dinner… you get the point. We have all been in a trade that is either going extremely well or extremely poorly, however, we keep asking, “hmmm… when should I sell?”. What I have learned is that you should know the answer to that question before you even buy a single share of a company. Not only so, the answer to that question varies from trader to trader, depending on if they are a technical trader, or a fundamental one, or if they depend on both. For the purpose of this post, I am going to talk about a reason, that no matter what kind of trader you may be, should scream SELL!
I have learned that the simplest things have the most effects when it comes to trading. I have tried to learn complicated technical analysis and complicated valuation techniques that can help potentially forecast the future of companies, however, I have come to realize that by keeping it simple, you can really do well.
“Simplicity is the ultimate sophistication.”
So, I would like to begin this lesson by saying this:
If your company, at any time, does a secondary offering or a private placement, sell your shares.
What is a Secondary offering?
In order to explain what a secondary offering is, let me first explain what a primary offering is. A primary offering is seen when a company has matured to a point where they feel it is time to go from a private to a public company and being registered with the Security Exchange Commission (SEC). This is what is called “Initial Public Offering” or IPO. By doing so, the company issues the shares on a secondary market such as NYSE. Publicly traded companies can then issue additional shares after their primary offering – their IPO – in what is called the secondary offering. By doing so they dilute the shares and thus the overall value of each share.
For example, if Company A has 10 shares worth $10, but they decide to do a secondary offering, by adding 5 more shares to the pool, the $10/share price will be diluted to $6.67/share.
10 x $10 = $100 / 15 = $6.67
I hope that was simple enough. Let us play a pretend game as to what will happen if you don’t sell your shares, and we’ll use Sientra as an example here.
We all have this tendency to get emotionally attached to a company. I mean this is your baby! You’ve read all about them, you know every little detail about the company inside out, the little free time you have, you’re always checking stocktwits and reading people’s comments. You’re liking the ones that say positive things and usually end their comments with “BULLISH”, and you know what the company is on a fire recently! Analyst after analyst is increasing your stocks price targets and there is nothing in the world that anyone can say to you about your baby (your stock). You know what? Things are going so well, you’re going to double down with more shares and buy some long-term options on this stock, because there is nothing that is going to stop this locomotive. When you think that nothing could possibly happen, you get the news that the company has done a secondary offering. So, your favorite stock takes a hit, so what? You’re up so much that it doesn’t matter. Right? Wrong. That stock will go lower and lower day by day and you’re sitting there scratching your head, thinking what on earth happened to my baby?
Well, let us dive deeper into the inner workings of a secondary offering. Let us look at the reasons as though why a company may do a secondary offering. Companies have a tendency to do a secondary offering in various situations, such as:
- There is a not enough cash available to run daily operations, thus, the company needs to raise cash, and one option is to do a secondary offering of shares.
- More capital is needed to expand operations.
- The management sees that the current stock price is high and therefore, would like to take advantage of the shareholders euphoric state and thus raise more capital for the company.
Issue number 1 is a concern for any type of investment you make, a company with poor cash flow will be a concern going forward, as it suggests a poor business model. Issues number 2 and 3 are also a concern for the overall momentum of the stock. By observing the price action, you can see that the stock begins to take a break as momentum begins to fade. Companies must approach an investment bank to issue shares, thus word may get out the company is doing a secondary offering. As a result, you may see an increase in short volume on the stock as well, all in anticipation of the secondary offering. Increase short volume will drive the stock price down even further which will be compounded with the number of momentum traders exiting the trade. Secondary offerings won’t be kind to the investors, because management has the tendency to take full advantage of this situation, thus, you can expect them not to only acquire cash for today, but also a nice cushion for future operations as well. Additionally, if the management decides to spend the money raised on for instance a new production line, this will result in increased costs, which in combination with diluted shares can result in depressed earnings. Poor earnings will also drive a stock price even lower.
In case of Sientra, the stock is down almost 75% from its 52-week high. The signs of selling were all there to see, so let us go through them:
- The company’s price action started to act funny for no apparent reason, other than the FDA decision taking longer than expected – down about 10%.
- The following earnings call, they mentioned that they are experiencing delays which should raise concerns as this can be a sign that cash-flow may be a concern in the future – now down about 20%.
- Company does a secondary offering – down about 25%.
- Company does a second secondary offering – down about 75% from 52-week highs.
What happens when there is a secondary offering. Go through the gallery for more detailed images.
As you can see this can be a snowball effect that can really affect the stock with momentum. This is something that we have to be cautious of and protect ourselves against it. Thus, if you sense a secondary offering coming, it is best to place stop losses orders, so you can protect yourself against significant losses. If you are considering investing in a company who has had a secondary offering, it is best to wait until the price has stabilized and is showing an upward momentum. I know it’s your baby, but it’s better to buy it at a 60% discount, no?