Share Dilution and IPOs in your Index Funds

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ThisDinosaur
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Share Dilution and IPOs in your Index Funds

Post by ThisDinosaur » Sun Mar 05, 2017 4:48 pm

https://www.researchaffiliates.com/docu ... lution.pdf

Ideally, when you buy a share of common stock, you are purchasing a fixed percentage of a company and its earnings. In reality, there is nothing stopping the company from issuing new shares, at the expense of the ones already outstanding. In a total market index fund, the same effect occurs when a new public company is purchased at market cap.

William Bernstein did a study of this effect and showed that it would have kept index mutual funds returns well below GDP growth. In effect, company and fund managers are stealing your wealth and selling it to others to the tune of 2% per year on average. It could be much much higher (as high as 30%?!) in emerging markets. What, if anything, can be done to limit the effect of share dilution on stock returns?

IlliniDave
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Re: Share Dilution and IPOs in your Index Funds

Post by IlliniDave » Sun Mar 05, 2017 5:35 pm

I guess I can't quite connect the dots with your conclusion regarding index funds and IPOs. If a new company appears and is added to an index, and the fund manager adds that company to the portfolio, I now have shares in a larger universe of stocks so I don't see where anything was "stolen".

In the 13 years since that paper was published, has a total market index returned less than GDP growth? Were index funds returns even below GDP growth in the 10 or 20 years leading up to the paper? I imagine that's possible since the paper was written close to the 2001-2002 trough.

Company-by-company dilution is another matter. I don't think there's much an investor in common stock can do about it though. Maybe there's a way to create a low dilution portfolio, but would that create higher returns? Dilution is an argument in favor of companies that pay out dividends, because at least those aren't diluted after the fact the way share appreciation can be.

I generally like Bernstein, have read a couple of his books, but he's an arch conservative investor with a gloom-and-doom outlook (surprised he's not more popular here), as in everyone should work until they are at 50X or higher and stick with very, very conservative stock/bond mixes.

ThisDinosaur
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Re: Share Dilution and IPOs in your Index Funds

Post by ThisDinosaur » Mon Mar 06, 2017 9:28 am

I guess I can't quite connect the dots with your conclusion regarding index funds and IPOs. If a new company appears and is added to an index, and the fund manager adds that company to the portfolio, I now have shares in a larger universe of stocks so I don't see where anything was "stolen".
If you own stock worth 1% of a company, and they double the share count (say, a CEO exercises some stock options), you now only own 0.5% of the value and earnings of the company.

If you own a total market index fund, it is a proxy for owning an entire country's economy. Its only a proxy, because you don't have access to the privately held businesses, but close enough. Then your fund manager buys into the facebook IPO. It may seem like your buying a totally new enterprise, a new "universe." But FB makes its money from advertisers and those advertisers pay facebook instead of paying to advertise on Seinfeld reruns or whatever. You previously owned all that revenue through your TV broadcasting holdings, but now you have to liquidate some of your existing holdings to buy those revenues/that portion of GDP that you had already owned before. So the impact on your portfolio is the same.
Were index funds returns even below GDP growth in the 10 or 20 years leading up to the paper?
In the paper, Bernstein shows that stock price and dividend growth have always lagged GDP growth by around 2%. And the effect is consistent across countries. Probably as far back as the 19th c. Furthermore, he shows that fast growing economies in the midst of technological revolutions or recovering from catastrophic wars benefit entrepreneurs, but usually hurt shareholders of existing enterprises, even those that bought distressed companies at market bottom.

IlliniDave
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Re: Share Dilution and IPOs in your Index Funds

Post by IlliniDave » Mon Mar 06, 2017 11:20 am

Still, in a fund although theoretically I might lose 1/nth of the pre-addition stocks due to acquiring the new issue, I have the new issue to replace it with its revenue stream. It's just like any other adjustment to a portfolio's holdings. In simple share dilution of an existing company I have a smaller share of the revenue stream and nothing to replace it with.

An index fund may be a proxy to an entire economy, but if so that's not why I'm invested in it.

Are you sure you're reading the paper right? He showed that the net dilution is about 2%/year (new issues minus buybacks), but when you look at actual market total real returns the numbers are both implicitly net of the dilution, and typically higher than real GDP growth I believe. Are you thinking of earnings growth rather than GDP growth?

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Re: Share Dilution and IPOs in your Index Funds

Post by jacob » Mon Mar 06, 2017 12:44 pm

ThisDinosaur wrote: Ideally, when you buy a share of common stock, you are purchasing a fixed percentage of a company and its earnings. In reality, there is nothing stopping the company from issuing new shares, at the expense of the ones already outstanding. In a total market index fund, the same effect occurs when a new public company is purchased at market cap.
Just commenting on the quote.

There's also nothing stopping the company from issuing debt. I think we're beginning to reach a point (if we're not far past it already) where investors have forgotten what it is they're actually buying because the actual companies (bricks and labor) have been so abstracted into numbers (earnings and shares) which again have been abstracted into sets of numbers (indexes) that follow certain articles of faith (always goes up, blabla ... ).

There are THREE ways to fund a company. It can issue equity (an IPO is just the first time this happens). It can borrow. It can retain earnings (self-fund).

Rationally it will do whatever is cheaper. If this means issuing new shares instead of new bonds, so be it. For reasons that escape me, companies tend to be really bad at this always picking the wrong choice---issuing equity when share prices are low and debt when they are high.

If a company trading at $20 with 1M outstanding shares (so marketcap = $20M) managed to issue 1M new shares offered at $20, it would not dilute the share value as such ... because that company would now have $20 million in cash on top of what it previously had. Overall, it was a fair trade. You have twice as many shares, but you also have that much more bookvalue. WLOG (setting the original P/B = 1), you now have twice as much bookvalue.

Now, what does happen and what you should/could be concerned about are companies issuing new bonds (borrowing money) in order to buy back their shares. This can fool people (especially at the more abstract levels(*)) to believe that earnings are going up because they're looking at EPS (skipping fundamental analysis) and not realizing that the main reason EPS is going up is that S is going down. There are companies out there currently who spend more money on dividends and share buybacks than they get from actual earnings. Because of the superficial P/E and EPS perspective, this makes those numbers look good. As long as stockholders don't look at how LTD and payout ratios are increasing, it looks like financial engineering magic.

(*) CAPE- and forward/market P/E-driven people in particular.

In PF-equivalent terms, it would be like one of the parents (shares) quitting work while making up for the shortfall by drawing down home equity for the lost salary. Result=> "Disposable income per job" just increased. To the outside world [that number] makes it appears as if the family just got a raise. Clever, no?

ThisDinosaur
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Re: Share Dilution and IPOs in your Index Funds

Post by ThisDinosaur » Mon Mar 06, 2017 2:10 pm

@IDave
Two independent analytical methods point to the same conclusion: In stable nations, a roughly 2 percent net annual creation of new shares—the Two Percent Dilution—leads to a separation between long-term economic growth and longterm growth in dividends per share, earnings per share, and share price.
Its possible I misread. But I interpret that to mean:
new share creation from old companies + new share creation from new companies - share buybacks = 2%/year average dilution

@jacob
This applies to me:
Jacob wrote:
(*) CAPE- and forward/market P/E-driven people in particular.
This doesn't:
certain articles of faith (always goes up, blabla ... ).
As for why companies tend to issue stock when share prices are low, I imagine that's because the same factors that keep your share price down tend to make credit harder to get at a favorable rate.

If a company issues new shares, it seems perfectly likely that that raised cash ("book value" as you call it) goes into somebody's pocket. Especially in the employee stock options example I used above.
reason EPS is going up is that S is going down.
Bernstein's paper (admittedly a dozen years old) specifically says buybacks have not outpaced share creation/dilution. Credit crash issue aside, do you have reason to believe that is no longer true? If I'm investing in foreign markets, how/where do I find aggregate debt to equity ratios and how should I use/interpret that information?

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Re: Share Dilution and IPOs in your Index Funds

Post by jacob » Mon Mar 06, 2017 2:30 pm

Anecdotally speaking, I rarely see individual companies issuing new shares (it's mostly REITs and struggling companies). Conversely, it seems to be rare for a company with a dividend program (I don't hold any non-paying companies) to not also have a buyback program. These observations cover the last 10 years.

Image

I still haven't read Bernstein's paper. I'd imagine that IPOs comprise the majority of equity offerings.

I'm not that much of a total market data nerd to know all these numbers. For individual companies, LTD/Eq is pretty easy to find. Good/normal ranges are 30-50%. There are rarely idiological unicorns who use 0%. In general, the more stable the business, the higher you can go. Such companies tend to have high ROEs (because most assets are debt) and low ROAs (because stable ~ not-growing).

IlliniDave
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Re: Share Dilution and IPOs in your Index Funds

Post by IlliniDave » Mon Mar 06, 2017 9:14 pm

ThisDinosaur wrote:@IDave

Its possible I misread. But I interpret that to mean:
new share creation from old companies + new share creation from new companies - share buybacks = 2%/year average dilution
That is true, but it is different than saying "... showed that it would have kept index mutual funds returns well below GDP growth" (quote from your OP). Going back to 1933 real GDP growth in the US has averaged 4-4.5% and real stock returns have averaged in the range of 6-7%.

I guess I don't really care, at least not enough to go reread the paper (read it 5 or so years ago), I'm just pointing out that regardless of the paper, stock market returns before and after it was published have generally exceeded GDP growth (and index funds track the overall market within a small fraction of 1%).

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cmonkey
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Re: Share Dilution and IPOs in your Index Funds

Post by cmonkey » Tue Mar 07, 2017 11:51 am

A good example of the debt/buyback/rising EPS would be IBM. You can get a decent picture of this by utilizing Wolfram Alpha. Replace IBM with your favorite company, then look for any buybacks. Very strong correlation between the three graphs.

If anyone figures out how to get the buybacks on to the first wolfram chart, let me know.

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