Getting down with dilution
BENJ GALLANDER and BEN STADELMANN
We are often asked, "How do you determine the upside for your investments and establish a sell target when purchased?"
Many aspects need to be considered in assessing a company's potential, but one of our standbys is a careful examination of historical trading prices. As we strive to buy an enterprise when it is out of favour, a good start is to see where the stock traded when it was popular.
However, these comparisons from the past are skewed when a substantial degree of dilution has occurred. When new shares are issued, each existing share accounts for a smaller percentage of the company. This usually makes each share less valuable and reduces earnings per share. It also decreases the stock's future upside, making those old stock charts potentially misleading and unreliable.
Shareholder dilution occurs for a number of reasons. Executive, employee, and director compensation packages frequently include options that increase the share count. Dilution can also occur when convertible debt or preferred shares are exchanged for common shares.
Dividend reinvestment plans (DRIPs) also, by definition, create new shares. It may only be a drip, drip, drip, but over time this can really add up. Sometimes DRIPs give existing shareholders the opportunity to purchase additional shares with their dividends at a discounted price, making this option particularly tempting.
Regulators occasionally require banks and insurance companies to raise equity to meet capital requirements or reduce their risk profile.
A common trigger for dilution is an acute shortage of cash. Junior mining and oil/gas companies often water down their shareholders because they often lack the revenues to feed their exploration and development phases. It's not uncommon for this cash crunch to be accompanied by limited access to debt markets. Therefore, they issue shares to keep the doors open.
Once mines or oil fields are operational, management may still issue new equity to finance large capital projects, promote growth or deal with negative cash flow. Using secondary offerings to finance large projects is also common in other capital intensive industries, including pulp and paper, aluminium smelting, steel making, manufacturing, and shipping.
Then there are the acquisition-hungry companies who like to pay with shares rather than cash. This can make a lot of sense if shares are overvalued. Of course, if the target has reached the same conclusion, they will demand a conversion ratio that can result in rampant dilution. This was a glaring hole in the "shares as currency" strategy of big tech firms in the 1990s and was a contributor to the subsequent tech wreck.
U.S. banks of all sizes have seen enormous expansions in their share counts. Bank of Commerce Holdings increased its count from 8.7 million shares in 2009 to 17 million in 2010. In this case, the historic chart and valuations implied the pre-dilution upside was between $14.00 and $16.00. Once the dilution was factored in, we reduced the initial sell target to $11.49.
Similarly, Bank of America went from 4.6 billion shares outstanding in 2008 to 9.8 billion in 2010. Our target price of $38.74 may seem lofty compared to the $16 level where it currently trades, but it is much lower than the old high of $55.
Another current holding that has been completely reshaped by dilution is St. Andrews Goldfields. In the bad old days, management unleashed waves of dilution followed by stock consolidations that effectively wiped out early shareholders. This 28-cent stock shows a ridiculous high of over $800 in 1987.
Finally, in 2010, a new regime led by Jacques Perron changed tack and the company stopped issuing shares. Perron has since moved on to Thompson Creek, but current CEO Duncan Middlemiss has kept share growth in check, which is one of the reasons we like this junior gold miner. The sale target of $1.20–$1.50 bears no resemblance to pre-dilution silliness.
Investors must carefully factor in the impact of shareholder dilution and recognize the apples-to-oranges situation it creates. Though some may choose to avoid companies with ballooning share counts, most investors who stick around long enough and are diversified across many industries are bound to run into the problem sooner or later. Instead of hiding from these issues, we prefer to measure the impact and invest accordingly.