Equity Dilution : The unseen enemy….

The startling observation that the BSE 100 Index’s “real” EPS growth lagged India’s “real” GDP growth over a three and five year horizon. Over the three year period, FY07-09, the BSE 100 real EPS CAGR at 4.7%, was much lower than the 8.5% real GDP growth. Over the five year horizon, FY05-09, real EPS growth at 8.4% was marginally below the 8.5%. The primary reason behind this was equity dilution.

There have been tomes written about how India will be the one of the key global growth engines for the next decade (at least) and how as investors we should hop on to the bandwagon by investing in equities. No doubt this appears to be compelling logic since “net profit” growth has often outpaced GDP growth rates. However, “real” EPS growth has not kept pace mainly because capital intensive companies have diluted their equity at regular intervals. Although there are some sectors/companies which are cash rich (frontline FMCG and IT companies are prime examples) most other sectors require dollops of capital in order to attain the next level.

While the overall financial leverage in our corporate sector has reduced over the past two years, this has often been achieved not through retained earnings but by refinancing high-cost debt through fresh equity issuances. Buoyant equity markets provide a temptation that few promoters can resist. There have been some promoters who have even candidly admitted that they are raising money while the going is good even though they do not have any concrete idea as to how to deploy it profitably.

The James Montier of GMO stating that between 1970-2001, US, UK and Germany too experienced the same problem.

As investors, this could hurt us in two ways :

1. Money which may have deployed more profitably ourselves, could be transferred into the hands of promoters with vague notions and intentions.

2. Other than EPS growth, constant dilution also affects the Return On Equity (RoE) adversely since most dilutions take place close to the current market price and RoE takes the premium component into account too. This is especially true in case of projects being commissioned over the next few years instead of the near-term (Eg. Metals, mining and oil & gas companies).

While, it may be difficult to avoid such companies entirely we can take some precautions in order to ensure that only a small portion of our portfolio is in companies prone to regular dilutions. Of course, often cash-rich companies with predictable earnings command a stiff valuation premium. However, there are bouts when the premium reduces. This especially happens during frothy times when risk aversion is very low and the companies’ conservative nature and the cash on their books is actually seen as a liability. Patiently waiting for such times may serve us well……