|
Published: July 13, 2010
Anybody who's ever divvied up a pizza
understands that the more people at the table, the thinner the
slices need to be to accommodate everyone. You don't have to
love pizza like I do to understand this principle. It's the same
with stocks. The more shares outstanding, the smaller the stake
in the company each share represents.
But most investors don't track the outstanding share count of
the stocks they hold, and that can spell big trouble.
Between 2000 and 2004, the share count for JDS Uniphase (Nasdaq:
JDSU) doubled from 90 million to 180 million. That's the
same as if the
stock split 2-for-1. You know what happens to a stock's
price after a split -- it gets cut in half. And well it should,
your stake in the business gets cut down the middle.
JDS Uniphase wasn't (and still isn't) profitable, but to
illustrate, let's assume it maintained annual
net income of $180 million. In that case, doubling the share
base would cause earnings per share to slide from $2 to $1. If
the market is only willing to pay a certain multiple per dollar
of profits (say, 20 times earnings), then we can reasonably
expect the share price to drop by half -- you can't escape the
cold laws of math. The stock actually hemorrhaged more than 98%
of its market cap during the years in question.
Simply put, if each share represents a smaller ownership claim
than it did before, then investors won't pay quite as much for
it -- regardless of whether the business is worth $10 million or
$10 billion. So putting new shares into circulation is a
sure-fire way to erode the value of a stock.
There are several ways this happens. Maybe a company is
lavishing its top executives with stock options that are later
exercised. Or it could be the result of convertible bonds,
preferred shares or warrants being exchanged for common shares.
Or perhaps it was just a secondary stock offering to raise cash;
we've seen plenty of those in the past year.
Unfortunately for investors, you won't see
the dilution data publicized much. Companies are quick to tell
you how much money they invested in repurchases, but rarely
mention the other side of the picture.
For example, between June 2002 and June 2005, Microsoft (Nasdaq:
MSFT) cheered itself for spending $18 billion to buy back
674 million shares. But at the end of the three years, there
were just as many shares outstanding as the beginning. Why?
Because the company issued 666 million new shares during the
same period. In other words, it was repurchasing shares with one
hand and doling them out with the other.
And then there are companies who treat their shares as a form of
currency for acquisitions. Networking giant Cisco Systems
(Nasdaq: CSCO) went on a major shopping spree in the "Dot.com"
era, buying up dozens of smaller rivals. Instead of paying the
old-fashioned way, the company simply handed out 1.7 billion new
shares between 1996 and 2002. For the most part, little regard
was given to valuation -- easy to do when you're spending
somebody else's money. In the end, CSCO shareholders paid the
price when the value of those acquisitions was later written off
one by one. Meanwhile, CSCO shares have been stuck in neutral
since the tech crash.
But the most toxic are cash-strapped companies with no choice
but to give equity stakes to bondholders or sell new stock on
the open market just to keep the lights on and the doors open.
Whatever the cause, the issuance of new shares is dilutive to
existing investors. With all this in mind, the companies in the
table below have ballooning share counts -- and disappointed
investors.
|
 |
By itself, an increase in the number of
shares isn't always a reason for panic. Sometimes there are
extenuating circumstances -- the entire financial sector has
been forced to recapitalize in the wake of the subprime
meltdown. And there are always growing businesses like Apple
(Nasdaq: AAPL) that have issued plenty in recent years and
still rewarded investors handsomely.
The key is to gauge how effectively a company is deploying the
proceeds -- returns on invested capital (ROIC) can be a good
start -- it measures how well a company puts its capital to use.
Those in the table above rank poorly by that measure and have
other red flags that warrant caution.
YRC Worldwide, for example, just orchestrated a $537 million
equity-for-debt swap to stay afloat. E*Trade just completed a
secondary stock offering and has over $1 billion in convertible
bonds that will soon be exchanged for common shares.
Action to Take --> If you
own any of the stocks listed above, you might consider selling
as your position has been heavily watered down... and that means
the value of your holdings has eroded. All things equal, I
prefer larger slices of stable companies loaded with meaty
assets and cash flows instead of seeing those shares become
worth less and less.
-- Nathan Slaughter
Editor
StreetAuthority Market Advisor
The ETF
Authority |
