Weekly Update: What Is “Share Dilution” and How Can It Affect Your Portfolio?

Luke McGrath

This year, in response to the coronavirus pandemic, the Federal Reserve has created trillions of new U.S. dollars.

One of the consequences of this has been to dilute the purchasing power of the dollars in your pocket.

But when it comes to the stock market, there’s a somewhat similar phenomenon.

That is, when you own shares in a company — and that company creates new shares — the effect is to dilute your ownership stake in that company.

It’s not quite the same, of course, because for publicly-traded companies this is a legitimate practice and so they’re more honest about what they’re doing… but still, “share dilution” is something you should be aware of.

That’s what today’s weekly update is (mostly) about.

Recently, a reader wrote to Sean MacIntyre and asked him a couple questions.

Sean, if you recall, writes for the Laissez Faire Letter and is a specialist in fixed-income and security analysis.

But his reply was so good and so informative that I thought I’d share it with you.

Read on…

Sincerely,

Luke McGrath
Managing Editor, Laissez Faire Letter

Laissez  Faire Letter Reader Mailbag

Dear Mr. MacIntyre,

I am a Laissez Faire Letter subscriber and would be grateful if you could respond to two disparate questions please:

Question #1: I have a lot of books and am wondering if you know the best way to sell them?

Question #2: I have been buying precious metals stocks for 20 years with some degree of success.

Until now, I have not been sensitive to the “number of outstanding shares” in a company. Recently, however, I bought a lot of shares of a precious metals penny stock — not realizing that they had something like 330 million outstanding shares.

I am ignorant about how my shares in this company will come back to bite me because of all these outstanding shares.

Additionally, this company sent out a press release last week stating that they were giving the principles in the company an incentive of between 1-2 million shares.

That stunned me.

I may be wrong, but I thought they had to write the shareholders to vote on further incentives for principles?

So far the Lord has been gracious and I have made money…

But I don’t know whether or not to be concerned by a) this very high number of outstanding shares and/or b) that this company seems to be able to create more shares for management without shareholder voting.

If you could make any comment on this I would be indebted to you.

Sincerely,
S.C.


Sean MacIntyre’s Reply


 

Sean MacIntyre

Thank you for your email. You caught me online right as I was working on my next column for Laissez Faire.

Regarding your books, there are a lot of ways to sell them — some simpler than others.

You can always sell them individually on Amazon or eBay. eBay is much easier to use for folks who don’t have experience selling online. And there’s a bit of money to be made here: Both my mother and mother-in-law are retired and earn a hefty side income by going to thrift stores and selling books and other tchotchkes on eBay.

The drawbacks here: You have to create a unique sales page for each book (including writing a description and providing a picture) and you have to ship them individually (you can charge about $3.99 to $4.99 for shipping, ship by media mail, and pocket the difference), which becomes a time commitment with copious schlepping involved.

Alternatively, you can use a site like Decluttr. You just enter the ISBNs of the books, they’ll give you a shipping label, you send in your books, and they pay you (or donate to a charity of your choice). There’s some risk in sending strangers books and expecting payment — but I’ve had no trouble with them, and I’ve seen very few complaints compared to other sites that do this.

The drawbacks: They pay a pittance! Unless you’re sending them dozens or hundreds of books, you won’t get much back.

Similar to Decluttr, there’s an Amazon Trade-In service, but they only provide compensation in Amazon gift cards.

Regarding the mining company shares, I have to tell you flat out: I’m a licensed ​investment​ advisor and fiduciary in Japan, but I am NOT licensed to give personalized ​investment​ advice. To be able to analyze and recommend stocks in publication, I have to speak generally and to a mass audience. So any thoughts I have on your situation with these mining stocks, I have to write in such a way that it could be helpful or apply to anyone.

That said, what you are describing with this miner is called “share dilution.” The same way printing money would (in a rational economy) diminish the buying power of a currency, “printing an infinite number of shares” diminishes the value of each individual share.

About the lack of a shareholder vote on the matter: The vote requirement regarding equity compensation only exists, I believe, for companies listed on U.S. exchanges. If this is a Canadian company, the rules might be different.

Now, is share dilution something to worry about? Often. Is it something to worry about in this case? I’m not certain.

Barrick Gold, back in 2001, issued about $31 million worth of shares as compensation, which — if this type of compensation appeared on its balance sheet and regulatory filings — would have reduced the company’s profits by a whopping 32%! Yet the company has stayed afloat, rewarded investors at times when gold prices spiked, and has attracted Warren Buffett as an investor recently.

Tech companies have been making dilutive share issuances for decades. Heck, Tesla just did this yesterday, and the stock continues to defy gravity.

So share dilution sometimes matters and sometimes does not. If you’re interested, there’s a great article about share dilution on Seeking Alpha.

Now, when it comes to this gold miner “paying” executives with 1-2 million new shares, based on its outstanding shares (“float”) this should theoretically only impact the value of your shares by at most 0.6% (2 divided by 330). Additionally, 330 million shares seems like a lot, but it’s fairly common for public companies (even small miners) to have a float this large.

If you’ve made money with this company, that might mean the executives have been doing something right, and so should be compensated accordingly. Better to pay them in shares than sacrifice the cash in the bank the company could instead use to fund mining operations — at least, that’s my thinking from a business perspective.

By that logic, if one continues to have faith in the business, the executives, and the potential opportunity… and so long as the company doesn’t go hog-wild with dilutive share issuances… then I don’t think one should have a problem with this particular move.

Apologies for the lengthy email, but I wanted to make sure to touch on everything you brought up.

Thanks again for your email. I hope it helps.

Best,
Sean

Sean MacIntyre is a former university professor, an entrepreneur and a specialist in fixed-income and security analysis.

Luke McGrath

Written By Luke McGrath