Ex-Rights

Ex-rights (meaning “without rights”) is a term used to describe a stock that is trading without the entitlement to participate in a company's upcoming rights issue. A rights issue is an invitation from a company to its existing shareholders to purchase additional new shares, typically at a discount to the current market price. Think of it as a special, shareholders-only sale. To manage this process, the company sets a record date. Any investor who owns the stock on that date gets the “rights.” However, because it takes time to settle stock trades, exchanges set an ex-rights date, which is usually one business day before the record date. Starting on the ex-rights date, the stock trades ex-rights. Anyone buying the stock on or after this date will not receive the rights; the seller keeps them. Consequently, the stock's market price will typically drop on the ex-rights date by roughly the value of the rights. This isn't a real loss in value but a mechanical adjustment, reflecting that the stock no longer carries this valuable entitlement.

Imagine your favorite local coffee shop announces that on Friday, every customer who has a “Loyalty Card” will get a voucher to buy a coffee next week for half price.

• The stock with rights: Owning the coffee shop's Loyalty Card before Friday is like owning a stock before the ex-rights date. The card's value includes the future benefit of that half-price coffee voucher.
• The ex-rights date: Friday is the ex-rights date. The shop starts giving out the vouchers.
• The stock trading ex-rights: If you try to sell your Loyalty Card to a friend on Friday afternoon, they won't pay as much for it as they would have on Thursday, because you've already claimed the voucher. The card is now “ex-voucher.”

Similarly, when a stock goes ex-rights, its price drops because the valuable right to buy discounted shares has been “claimed” by whoever owned the stock the day before. The value isn't gone; it has simply been separated from the stock and given to the shareholder in the form of a right.

The price decline on the ex-rights date is one of the most misunderstood events on the stock market. It’s not a reflection of bad news or poor company performance. It’s simple mathematics. The total value of the company is now being spread across more potential shares, and the right to buy those new shares has a value of its own.

To estimate how much the price will drop, investors calculate the theoretical ex-rights price (TERP). It’s a weighted average of the old shares and the new, discounted shares. Let's walk through an example:

• Company: Value Investing Co.
• Current Share Price: $50
• Rights Issue: A “1-for-4” offer at $40 per share. (For every 4 shares you own, you can buy 1 new share for $40).

Let's calculate the TERP:

1. Step 1: Calculate the cost of 4 existing shares: 4 x $50 = $200
2. Step 2: Add the cost of exercising the right to buy 1 new share: 1 x $40 = $40
3. Step 3: Find the total cost for the new total of 5 shares: $200 + $40 = $240
4. Step 4: Calculate the new theoretical price per share: $240 / 5 shares = $48

In this scenario, the TERP is $48. On the ex-rights date, the stock price should theoretically fall from $50 to $48. The $2 difference represents the value of one right for each of the original four shares.

For a value investor, understanding the mechanics of a rights issue is crucial to avoid mistakes and make informed decisions.

A key principle of value investing is buying great companies at a discount to their intrinsic value. The price drop on an ex-rights date is not a discount. You are simply paying a lower price for an asset that now has fewer entitlements attached to it. Buying a stock ex-rights for $48 is no “cheaper” than buying it with rights for $50 the day before. The underlying value hasn't changed, only how it's packaged.

If you are a shareholder and receive rights, you have three choices:

• Exercise the rights: If you still believe in the company's long-term prospects and have the capital, exercising your rights to buy new shares at a discount is often the best move. This maintains your ownership percentage and prevents dilution.
• Sell the rights: Rights are transferable and trade on the market for a short period. If you don't want to invest more money, you can sell your rights to another investor. The cash you receive should compensate you for the dilution of your stake.
• Let the rights expire: This is almost always a mistake. Letting your rights expire worthless is like throwing away cash. Your shareholding is diluted, and you receive zero compensation for it.

While a rights issue can be a positive sign—for example, to fund a smart acquisition—frequent rights issues can be a red flag. A company that constantly has to go back to its owners for more cash may be poorly managed, unable to generate sufficient internal cash flow, or burning through capital on unprofitable projects. A true value investor must always ask why the company needs the money and scrutinize the plan before participating.