Beware Stock Dilution When Long-Term Investing

When you invest in a business, it can be overlooked that you need to draw a distinction between the per share results of a business and the results of the business itself. It is not enough to say that, say, Apple grew it profits by 10% to figure out what is going on with your wealth, because you do not own the entire business and the capital structure of any business is subject to stock repurchases (which can raise per share profits at a rate higher than the overall growth of the firm) or the issuance of new shares that results in stock dilution (which can cause your share to represent lower profits than the overall growth of the firm).

It’s always there in the background of every business I study. How is that one, single share protected over time?

When I look at a business like Wal-Mart, I see a company that is phenomenally dedicated to the interests of its long-term shareholders. The business itself is doing exactly what it was doing in 2009. It earns $14.2 billion in profits. That was the cumulative profits in 2009 and that’s what the cumulative profits will be in 2018.

But yet, Wal-Mart takes enormous chunks of cash flow and repurchases shares of the business and has them destroyed. In 2009, your single share represented a claim on 1/3.7-billionth interest of the overall firm. Over the past nine years, Wal-Mart has repurchased 800 million shares. Now, your single share represents 1/2.9-billionth interest in the firm.

This sounds abstract and theoretical, but the end result is that your single share now represents a claim on $4.08 in Wal-Mart’s profits rather than $3.66 in Wal-Mart profits, not because Wal-Mart has grown, but because it has systematically found 800 million shares of Wal-Mart from selling shareholders over the past nine years, took the shares, and had them destroyed so that the percentage ownership of the firm for the remaining shareholders would increase. That extra $0.42 may not sound like much, but given that Wal-Mart is usually trading at around 16x earnings, but each share ought to be worth around $6.72 more because of the increased ownership position. For someone with 100 shares, they captured $672 in value as a result of the buybacks.

From an investor perspective, that is the best case scenario–your share becomes more valuable.

On the other end, you have to watch out for those high-debt, cyclical businesses that issue and repurchase stock at the wrong time. Take a business like Anadarko Petroleum (APC), a publicly traded oil and natural gas explorer. It has 2.39 billion barrels of oil and an astounding replacement rate in which it finds/acquires 4.32 barrels of oil for every barrel of oil that it produces. If you were just looking at the business, you would love to own it for the long haul, and the volatility would be offset by high returns.

But debt, and its effect on the capitalization of the business, matters. It has the earnings power of $500 million to $1 billion in normalized profits. It carries $16 billion in debt. That creates huge problems when the price of oil collapses. When oil fell between 2008 and 2009, it had to issue 40 million shares. And it had to do so when prices were at $42 rather than $80, so it only received half the capital it would have received had it accessed the capital markets a year previously.

Then, when oil fell in 2014, it had to issue 40 million more shares. Again, it had to do so at $43 per share rather than at $113 per share had it done so even earlier that same year. I love these Texas oil-catters, but dang, must they always go to the bank and borrow the maximum amount they can get their hands on?

Then, when oil recovers, it tries to repurchase those 80 million shares. It’s a terrible see-saw of repurchasing stock when it is expensive and issuing it when it is cheap. Sure, business conditions required it, but the antecedent error is not having conservative financing in the first place so you don’t have to buy high and sell low. In 2008, there was 458 million shares. Now, there is 495 million. Basically, of the 80 million shares that got issued at low prices, 40 million shares got repurchased at high prices.

That is why the stock has only gone from $32 per share to $52 per share in the past generation (i.e. 2000 to the present). You can’t systemically build wealth when the individual share is not respected. If a wealthy investor would have shown up with $5 billion in cash, took the company private in 2000, and held onto the same assets but had a capital structure flush with the $2 billion cash leftover after my hypothetical takeover, the value of the same business would have quintupled.

Conservative financing is hard when you’re getting started because it feels like you’re moving in slow motion, but my gosh, it protects you from undoing years of your life when the adverse conditions strike. Anadarko owns great assets, but the financing and the stock dilution mean that shareholders will never capture results nearly as great as what the underlying assets could provide.

The business itself matters a whole lot. But it only tells part of the story. You have to take your analysis down to the “per share” level. That is, after all, the measuring stock. Over time, does management take care of the share, treating as a seed to grow? Or is the share just something to be used for empire-building and the next round of financing? If the latter, you have to be careful, because a company’s acquisition may not lead to growth in shareholder wealth, but rather just an expanded sphere of influence for the parent company. Unless a company is issuing a stock to purchase fast-growing assets, I consider stock dilution over time to be such a significant demerit against the company that it functions as a rebuttable presumption against investing in the company, overcome only be exceptional circumstances.