It may still be vivid in many investors’ minds the game of the century, ‘Caritas’, the Ponzi* scheme of the early 1990s in Romania. It was owned by Ioan Stoica and attracted over 400,000 investors who gambled over 1 billion dollars because it promised to repay 8 times the amount invested. Although Caritas lasted for just over 3 years it finally went bankrupt in August 1994 with a debt of over 450 million dollars. Nobody knows why this company was allowed to gamble with people’s savings and where the money went but this is another topic altogether.
What we are witnessing today in Romanian stock exchanges is a reminiscence of the 1990s Caritas. There are several layers of investing in Romania that would make the best financiers on Wall Street feel stupid. Most companies who are using the spot exchange as a platform for their company’s financial development are small and may have difficulties running to banks for financing, therefore they use the local spot exchange disintermediation facilities.
So how does this process work? Well, let’s use Armax, Dafora, and Albalact for example. They all raise capitalization by issuing millions of shares to existing shareholders for an under-market valuation at nominal value rather than real value. This not only allows existing shareholders in these companies to subscribe freely or large discounts to par value but it also allows a free run-up to the price by overcrowding the buyers who in the same case see it as free money. It is to everyone’s dismay that Biofarm one of the darlings of BVB following a 25% dilution with no real change in the fundamentals returns a 12.50% overnight gain. We have many other examples with some other BVB Majors.
One interesting fact is nobody is really worried about the consequences of this dilution. Was it necessary to raise a couple of million euros for capital expenditures to completely obliterate the capital structure of those companies? We believe not. Someone at the other end of the stick will pay the price when all is set and done. Financial responsibility comes with a price. There is no free lunch. Or is there one?
Well, it seems that there is free lunch since executives from Armax, Dofora, Flamingo, and others walk away with millions. How is this possible we are asking ourselves? In the case of Albalact, a 230% dilution resulted in more than double capital appreciation since the shares closed up at the same level when the dilution occurred. Let’s look at ARAX, the company issued stocks at 0.10 lei (Nominal Value) worth 5.6 million lei in February. The existing shares were diluted at 2.25/1. However, the stock quadrupled since the news was announced. Although initially with a stake of over 50%, the executives were content to sell for lei 2.50/share since they got back under the dilution at lei 0.10 an astronomical 2500% return in only a few months on new shares issued and still maintain majority ownership.
There is no problem with locking profits and making money, but it raises a red flag, about how long will the party last. There are some factors that can not be overlooked. First what happens when the companies will not deliver on their promises? These companies are priced from a fundamental perspective beyond perfection and any reasonable valuation model. And more dilution is on the way. How do we explain Impact’s 1 billion share outstandings, which beg for a DCF analysis to justify the valuation?
Is there a correlation between the number of shares and the market capitalization of a company? It is certainly not supposed to but everything is possible in the current Caritas mania that grips the Romanian markets today. Who gets the carrot and who gets the stick? Sophisticated investors will be the first ones to decide when to bail out and small investors will be caught holding the short end of the stick.
One eloquent example is (EXC) Kandia. Although the stock ran up to 3.90 Ron/share last week when the big news came out with Cadbury Schweppes buying the Romanian company at 2.90 Ron/share, what followed along with a fear of delisting from the stock exchange was a clobbering 25% price to 2.80 Ron/share in just 2 transaction sessions.
There is no reason why one should buy a stock at a 60% premium from what an insider sells. An insider sold a 13% stake in Prospectiuni S A Bucuresti at 240.47, but the stock went up to 385.00. This is an anomaly and although we might assume that this creates “liquidity”, it brings no real fundamental value to a company. If anything it should raise red flags of the exit strategy.
There is an implied assumption that Pension Funds will invest in existing companies listed in the Romanian stock exchange and will sustain valuations. Well, that may or may not be true. The pension funds will not throw the pensioner’s money into highly risky companies unless this option is fundamentally sound. Also, there is a management issue. Pension funds do not invest in companies whose founders and management are bailing out. Large caps conservative well run and highly liquid stocks are the ones that will benefit the most from the fund’s money.
One can avoid capital loss in case we see a repeat of a Caritas-like situation. The risk management strategy might consider the following. First: Everyone should take part in this “Free Lunch” bonanza while it lasts, but the emphasis on an Exit strategy should be clear. Second: Lookup for Insider trading and buying. This is a good indicator and it should give you reasonable expectations or at least raise flags to investigate further. Third: Remember everyone is buying stock to make money, but there are many reasons why someone sells or reduces. Fourth: Don’t pay more than what insiders sell for. Fifth: Learn about the management of the company. Sixth: Look up fundamental and technical indicators. Seventh: Know about the business environment (operation, competition, regulation, etc.). Eighth: Listen to your broker but remember the brokers are making money on your trades. Ninth: Consult a financial advisor if necessary.
A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns (“profits”) to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business, named after Charles Ponzi.
Horatiu Tocan
(With some contributions from Mukul Pal)