In the last article, I went through a couple of scenarios that could result in an investor’s position being diluted out by further equity issuances by the company itself.
While these situations don’t really have a major impact on the value of the investment itself (increasing the amount of equity on the company’s balance sheet might actually improve its overall position), it does decrease the investor’s proportionate holdings in the company, as well as the re-investment value of their returns. Lastly, equity dilution might decrease the ability of a company to raise capital in the future, which reduces its ability to handle future risks.
The first cause of equity dilution that was discussed in the previous article was dilution by major issuance. Whenever a company enters into an agreement to issue new stock for a large placement, they are explicitly diluting out all other shareholders of their positions (including management positions). However, it is important to remember that shareholders all maintain a preemptive right to maintain their proportionate holdings.
This means that, in issuing the new equity offering, the company must first offer all existing shareholders the right to purchase new units, in order to maintain their percentage ownership of the company. This allows investors to maintain their percentage of voting rights in the company, as well as to keep their equity share of the assets in the company.
As a value-based investor, that share of the claim on assets is a major portion of our valuation model, and therefore an important investment consideration. If we can’t maintain an effective amount of asset-based insurance against our investment, we need to re-consider whether or not we want to continue holding the position at all.
The second cause of equity dilution that was discussed was dilution by stock-dividend. While stock-dividends can be of real benefit to personal investors, it is important to recognize that they can easily create an equity bubble, which will burst as soon as investor confidence in the ability of the stock to perform over time decreases. Investors are therefore exposed to not only the underlying value of the company, but also the market’s expectations of how well the company will be able to perform in the future.
As a personal investor, we have two main defenses against this kind of dilution. Firstly, we can simply opt for cash-dividends instead of stock. Most companies will allow you to do this, but it’s important to verify before you buy just in case they don’t. Secondly, a personal investor can protect against equity dilution from stock dividends by selling the extra equity and using it to diversify into other securities. This allows you to maintain exposure to the company upside overall, but allows you to take advantage of the inflating equity bubble to diversify out of the associated risks. The end result? You keep your portfolio from becoming over-weight in a single position.
Realistically, a personal investor doesn’t have the time to worry about smaller details like dilution. When building a smaller portfolio, we should therefore avoid any semblance of situations where this could be a possibility, because the implications are not worth our time. However, if we feel as though those kinds of returns are extremely important to us, diversification is probably the best way to handle the risks, given our investing capabilities.