With the median retail preferred stock seeing a nearly complete recovery back to “par” from its March drawdown means further capital gains are going to be harder to bank from here on. This means that investors looking to extend their gains will need to find another source of returns besides current middling yields. One technique that has enjoyed some popularity among the more active investors is “flipping” newly issued stocks. In this article we take a look at this technique to see if it can add alpha to investors’ preferred portfolios.
Flipping Out Over New Issues
For all of the advances over the last decade in electronic trading, transparency of pricing and ease of market access the retail preferreds market remains weirdly archaic in some ways. The way many retail preferreds come to market is first via the so-called “Grey” or “Other OTC” Market. For example, on 8-June Public Storage issued the new 4.625% Series L shares with a permanent ticker symbol (PSA.PH). However, because it takes a few days to get the shares listed on NYSE the underwriters, who have already priced the shares, aren’t particularly keen to warehouse them and take the price risk. Instead, they acquire a new ticker for the shares, in this case, PUBXL and start selling the shares to investors prior to their listing on NYSE.
In order to be able to trade shares in the OTC market, investors need to know two main things. First, they obviously need to be aware that there is a new issue out there. Normally, companies make an announcement via a press release which investors can track directly on a platform like Business Wire or on a news aggregator like Yahoo. Alternatively, portals like QuantumOnline.com also list recent new issues.
The second key issue for investors is that they need to both know the OTC ticker of the new issue and make sure that their broker is set up to trade the new issue. Some brokers can take a day or two to sort out the pipes and make the issue available for trading.
Does It Work?
To kick off let’s motivate the discussion with a few preferreds. Public Storage is particularly top of mind not just because of a newly issued series but because it is a prolific and frequent issuer. Let’s take a look at how three of its series issued over 2019 have fared over the first month. All three series closed above 25 on the first day of trading and then slowly traded up over the first 21 business days.
We have to be mindful that as dirty prices, they would reflect around 10-12 cents of accrued by the end of the first month depending on the series so some of the rise is due just to the dividend. Overall, however, it looks like all three series enjoyed pretty strong growth with an average rise of about 2%. And although the preferred market did well in 2019 – it surely did not return anywhere near 24% annualized in pure capital gains.
Let’s take a more systematic approach and look at all the $25-par preferred IPOs over 2019. The reason we choose 2019 is to control for what was a very unusual trading environment in February to April of this year that would skew the results plus the fact that the new issue market was effectively closed in the latter stages of the first quarter. To make sure this is not a one-off we also checked the performance of about a dozen new issues since April of this year and the results look very similar.
The chart below shows the average return path of 94 2019 IPOs starting with the closing price of the first trading day. Arguably, we should be using the open price of the first trading day as the first data point, however, not all investors would be able to transact at the open. The chart shows a pretty steady rise in returns over the first month – at a net price return of about 1.4% (after subtracting the accrued and the above-par first close) and an annualized return of nearly 17%. This suggests that you don’t have to jump on the stock out of the gates in order to enjoy decent returns. You can even wait for it to start trading on the exchange though that will give up about a third of the gains.
An average hides a lot of variation. Let’s take a look at the box-and-whiskers plots chart of each trading day over the first month. The box plots measure the range of prices with the box indicating the range of the first quartile and the third quartile, with the whiskers showing the tails of the distribution and diamonds indicating outliers. The bars in the box indicate the median prices.
This median line through the boxes is similar to the average line in the earlier chart – showing steady progress in the median price of new IPOs through the month. Interestingly, the the bulk of new IPOs don’t trade further than about 2% below “par” and 6% above “par”. This shows that the assymetry of the price distribution favors early buyers.
Another important question for investors is how to manage the entry point. In the chart below we compare the daily average open to the average low and high. The chart shows that the low is about half a percent below the open suggesting that there are opportunities to enter the trade at an attractive level after the open.
If we look at the return from the open to the close on the first day of trading we can see that there is a small pop on the first day however it is not particularly large though the variation is fairly wide.
Another important data point is the first day’s low versus the open. The chart shows that on average we see a half a percent drop from the open to the day’s low which again suggests that entering with a limit order a bit below the open might make sense for most stocks.
Why Does It Work?
The obvious question is why does buying new issues work?
One reasonable response here is that – well it works at the theoretic “mid” price but doesn’t work very well once you take bid/offer costs into account. This point doesn’t invalidate the strategy, but it does point to the importance of using limit orders and possibly stagger them for larger trading sizes.
A reason why this strategy appears to work is a circular suggestion that the presence of flippers themselves pushes up the price. This is certainly true although the fairly straight performance line of the strategy suggests that the flipper demand is small relative to the demand of the broader market once the trading in the stock gets established.
A second reason could be that the broader retail community takes up the new issue from either spare cash or by rotating out of other assets. Once the permanent ticker is known and exchange trading commences more retail investors become aware of the new issue and buy the stock.
A third reason could be due to a yield-advantage. In other words some stocks could be issued at a yield advantage to existing series so the appreciation of the new series has more to do with it moving towards fair value rather than anything else. This explanation rings true to us based on some recent issuance.
For instance, the recent Athene Holding 6.375% Fixed-to-Float Series C (ATHHL) was issued at a yield-to-worst similar to the 6.35% Series A (ATH.PA) however it boasted a reset yield similar to its initial coupon and 1% higher than the reset yield of ATH.PA. Plus it offers attractive yield upside given the base index 5-year Treasury yield is trading at just 0.45%. ATHHL was also more attractive than the 5.625% Series B (ATH.PB) unless Treasury yields go negative.
Another recent issue that looked more attractive than all other series of the same issuer was the Public Storage 4.625% Series L (PUBXL). The series has the highest yield-to-worst and the longest call protection period than all other series.
So, what are our takeaways for this strategy?
First, the strategy does appear to work although care should be taken in placing orders.
Secondly, there is no reason to chase the stocks out of the open – most stocks see lower prices from the open during the day. Plus the pace of appreciation is fairly linear over the first month.
Thirdly, the law of large numbers applies – the variation in performance is quite large so investors will get more consistent results by pursuing more opportunities in smaller size rather than going after one or two trades.
Fourthly, investors have to be mindful of the additional risk they are taking on by purchasing a stock. Investors pursuing this strategy as an alpha strategy can either hedge with a broader index or rotate out of existing holdings. This is particularly true if they already hold a series of the same issuer since new issues are often more attractive than existing ones.
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