Dilution

AS CORPORATIONS issue more shares and as new companies emerge, existing shareholders see their claim on the economy’s profits diluted. Indeed, the economy’s fastest growth often occurs among privately held companies. Ordinary stock market investors can’t buy into these private companies until they have grown large enough to be taken public in an IPO, or initial public offering.

The historical dilution suffered by existing shareholders has been estimated at around two percentage points a year by money managers Robert Arnott and William Bernstein (“Earnings Growth: The Two Percent Dilution,” Financial Analysts Journal, September/October 2003, Vol. 59, No. 5). In other words, if the economy grows at a nominal 5% a year, total corporate profits across the economy would likely also grow at 5%—but earnings on a per-share basis might grow at just 3%. If earnings per share trail the economy’s growth rate, share-price appreciation is also likely to lag, unless there’s an offsetting rise in the stock market’s price-earnings ratio.

Some good news: Dilution has all but stopped in recent decades, as corporations have used their spare cash to buy back substantial amounts of their own stock. One possible downside: It could be that corporations have been neglecting capital improvements and eventually they’ll need to start using their excess cash for major capital spending, at which point dilution could return with a vengeance.

Could you compensate by investing in faster-growing companies? For instance, would it make sense to invest in IPOs? Even though companies sold through IPOs are often growing fast, they typically prove to be disappointing investments. Why? Fast growth alone doesn’t make for a good investment. It also matters what price you pay for that growth.

That brings us to one of investing’s most counterintuitive notions: Often, slower-growing companies and slower-growing countries turn out to be better stock market investments—because they can be bought at more reasonable valuations.

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