Tuesday, March 17, 2009 0 comments ++[ CLICK TO COMMENT ]++

Share dilution a huge threat for shareholders

As if shareholders don't have enough problems with the economy, they will be facing a huge threat from share dilution. This has been an acute problem for shareholders of financial companies but is starting to migrate over to other industries. The big risk recently has been with cyclicals, particularly commodity businesses. I am not talking about some no-name junior miner facing cash flow problems. What we are facing is shareholder dilution for even the market leaders. The latest rumour, which would have been shocking an year or two ago, is that ArcelorMittal may issue $6.5 billion of shares. This is roughly 30% of market cap so you can see how expensive it can be.

It'll supposedly be a rights issue so shareholders that don't want to be diluted can avoid it if they are willing to pony up more money. But small investors sometimes don't have access to these rights offering (when Ambac did its rights offering, I wasn't offered anything) and generally may not have more money to pump into their holdings.

The problem with all this dilution is that it is occurring at very low share prices. Admittedly it is difficult for management to forecast collapsing demand and hence profits but it is still painful for shareholders to realize what is happening.

If the dilution is sizeable it also crystallizes quotational losses into real losses. That is, if the share price is irrationally low and below its intrinsic value, a shareholder only has a quotational loss. The share price will eventually recover if the intrinsic value is indeed much higher (at least that's what value investors implicitly assume.) But if the company goes and issues a huge chunk of shares at the low price, it turns into a real loss with no chance for recovery (the actual loss depends on the amount of dilution; generally it is not a total loss since the dilution tends to be less than 30% of outstanding shares).


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