Most of the time, when we discuss stocks that have been irreparably harmed, we are talking about companies that have gone bankrupt, or have seen prices deteriorate so much that investors will never again so the “good old days” (usually this is the result of some kind of technological shift or high fixed costs that can’t realistically be lowered).
Today, I want to talk about a third kind of harm: share dilution.
Citigroup is one of the best companies that comes to mind I can use to illustrate the principle.
Even though no one gets made mocked by the financial media quite like Citigroup (although it does trade positions frequently with Bank of America) in this regard, the truth remains that Citigroup is an immensely profitable banking enterprise. It’s so unpopular and it is involved in so many legal settlements that it is easy to miss if you don’t check out the company’s financial forms and dig through the information yourself, but Citigroup is actually making $14 billion per year in profits. It’s one of the four dozen most profitable enterprises in the world, although you wouldn’t be aware of that fact if you followed the headlines and never got around to studying the company’s actual fundamentals.
Within two years, Citigroup will be as profitable as it was in the years leading up to the financial crisis. So everything is going to work out for long-term shareholders, right?
Citigroup lost $32 billion in 2008. To stay alive, the company had to create equity, and create equity fast. That means creating shares at a time when the stock price had fallen by over 80%, so that the existing shareholders would have to share the wealth with new partners that were entering at once in a lifetime prices, diluting the existing owners substantially.
By the time the financial crisis was over and the final results tallied, almost six new shares got created for every share that had previously been in existence. A share count that had hovered around 500 million grew to 2.8 billion. Things got so bad that Citigroup had to do a 10-for-1 reverse stock split to superficially paper over their own folly; without taking into account dividends, Citigroup’s stock price will have to increase to $500 per share for the old investors to breakeven.
Profits will have to increase ten-fold for Citigroup shareholers to get back to where they were in 2007—in other words, you’re looking at a situation where investors will have to wait until 2037 to get back to where they were in 2007. That’s failure. Sure, it’s better than owning Wachovia, but monstrous one-time share dilution is a crippling event that will most assuredly trash an investment for the rest of your life.
How do you avoid companies that engage in catastrophic share dilution? Although companies can get somewhat creative with how they fail, share dilution usually has three warning signs you can look out for: high debt and/or low capital (this is usually exhibited by banks that have forgotten crisis memories and are lowering their Tier 1 Capital ratios and liquid reserves to try and bump profits to meet some quarterly estimate figure), high-fixed costs (think the old General Motors and retail outlets like Border’s and Barnes & Noble), or debt that proves high in hindsight (this is common in the oil and gas industry, where debt loads that appear manageable to an analyst studying the company suddenly becomes crippling if commodity prices dip for an extended period of time, and the company has to issue shares to stay alive).
Now, if you are particularly shrewd, you can come pick up the pieces after the company falls apart—Citigroup is worth at least $67 based on its total book value, and it is making $5 per share in profit. At some point, $2.50 of that will be distributed in dividends (it might take five years or so for the payout ratio to get there), and it could be even higher assuming Citigroup’s total profits are higher in 2019 than 2014.
As it stands, Citigroup is a perfectly healthy bank with a double-digit Tier 1 Capital Ratio making almost $15 billion in net profits. This is a small solace if you owned the company before 2007, because you paid the equivalent of $500 per share and now have to split the profits with six new people. But it is that foul aftertaste that can partially explain why Citigroup is so cheap today, and once it starts raising its dividend in a way that reflects the actual profits it is generating, the investors that buy the stock today are going to see some rapid price increases in short order. The enterprising investor has to be unemotional about the past, and that’s the hard part.