Share Dilution in Emerging & Developed Markets

[SimpleGift]

Will fast-growing emerging markets be the global equity winners in the decades to come? At first blush, it makes great sense, since the emerging economies today are growing at more than four times the pace of the developed economies. Won't this rapid GDP growth translate into outsized earnings growth and stock returns?

The "fly in the ointment" for emerging market investors is that stock price growth depends not on aggregate earnings — it's earnings-per-share that matters. Looking at the past ten years, comparing the annual GDP growth rates of the major emerging and developed economies (table below), emerging markets have been the clear winners, 4.5% to 1.1% real — however, developed markets had the better EPS growth rates, -1.0% to -1.6% real. What gives?

• 
  NOTE: Averages are simple arithmetic of the 6 major emerging and developed markets.
  Data Source: Schroders

The key factor, for emerging markets as a whole, is that even though aggregate earnings growth has generally been strong, the number of shares increased much faster than earnings. In fast-growing economies, the creation of new firms and the flotation of new shares is behind the vast majority of their growth — which dilutes the EPS for existing shareholders (table below).

• 
  NOTE: Averages are simple arithmetic of the 6 markets.
  Data Source: Schroders

BOTTOM LINE: While it makes sense to allocate part of one's equity portfolio to emerging markets, one shouldn't go overboard on the promise of rapid economic growth, and shortchange the slower-growing developed markets of the world.

Your thoughts?

[asif408]

Thanks for posting, Todd, always insightful. Fortunately, I am an Bill Bernstein acolyte and know that, at least historically, the fastest growing economies tend to have lower long term returns than slow growing economies, and a large reason for that may in fact be share dilution. I'm amazed how much this myth continues to propagate, as I still see it regularly referenced and implied in the financial media that fast growing economies offers better stock return prospects than slower growing economies.

I'm curious how those numbers play out when you compare the actual index compositions, such as EAFE vs. MSCI EM (if that information is available). Is it actually worse or better than the numbers you posted?

In general, I agree this might be a negative for EM investing, but I don't think it would be enough to exclude EM. It does imply that you should stay well diversified by country in EM, as some EM countries' share dilution is not much different than some of the developed markets. I personally tilt a bit away from China in my EM allocation for that reason.

[SimpleGift]

I'm curious how those numbers play out when you compare the actual index compositions, such as EAFE vs. MSCI EM (if that information is available). Is it actually worse or better than the numbers you posted?

The data from Schroders was not presented by market-cap weight, just simple arithmetic averages as in the OP. But since their data set includes most of the major emerging and developed countries, one could multiply their respective dilution rates by their market-cap percentages, and come up with rough ballpark figures for the major indexes, I believe.

Since the U.S. is over 50% of the developed market-cap index, and has had a net share concentration rather than dilution over the last decade (buybacks exceeding new share issuance, chart below), the cap-weighted comparison between emerging and developed countries would be even more striking than the one in OP.

• 
  Source: Yardeni

[SimpleGift]

I personally tilt a bit away from China in my EM allocation for that reason.

It's worth noting from the data in the OP that, even though China had massive share dilution and the U.S. had net share concentration, the annual EPS growth rate of Chinese mainland companies over the past 10 years actually ended up exceeding that of U.S. companies, 2.0% to 1.5% real.

Which is why it still makes sense to allocate to emerging market stocks, in my view — but to just not overdo things.

[JBTX]

It’s an interesting point I hadn’t really thought of.

So if you adjusted for company size, how does the dilution compare? Do US companies of comparable size dilute less or more to EM?

I’ve always liked the idea of EM but there are pitfalls. Between this, their disproportionate weighting of natural resources and utilities, and a non trivial portion of firms that are either run by or deeply intertwined with the respective government, which may have other motives than adding shareholder value - there are a lot of pitfalls to be aware of.

[SimpleGift]

So if you adjusted for company size, how does the dilution compare?

The only data I've seen on company size and share dilution is from a 2016 study by WisdomTree. Over the 15-year period from 2001-2016 (chart below), U.S. large-cap stocks had an average annual net buyback yield of 1.3% (more buybacks than new share issuance), while U.S. small-cap stocks had a net buyback yield of -2.3% (more new share issuance than buybacks).

• 
  Note: Large-caps are 500 largest U.S. companies; small-caps are the smallest 2,000.
  Source: WisdomTree

According to the study, most of the small-cap new share issuance came from the higher-priced, small growth companies (with an average net buyback yield of -5.5%) — and the lower-priced, small value companies issued far fewer net shares.

Do US companies of comparable size dilute less or more to EM?

No hard data, but it seems share dilution would be directly related to company growth rates. Assuming comparable size, if emerging market companies are needing more capital and thus issuing more new shares and spinning off more new enterprises than their U.S. counterparts, their dilution rates would likely be higher — and vice-versa.

[JBTX]

So if you adjusted for company size, how does the dilution compare?

The only data I've seen on company size and share dilution is from a 2016 study by WisdomTree. Over the 15-year period from 2001-2016 (chart below), U.S. large-cap stocks had an average annual net buyback yield of 1.3% (more buybacks than new share issuance), while U.S. small-cap stocks had a net buyback yield of -2.3% (more new share issuance than buybacks).

• 
  Note: Large-caps are 500 largest U.S. companies; small-caps are the smallest 2,000.
  Source: WisdomTree

According to the study, most of the small-cap new share issuance came from the higher-priced, small growth companies (with an average net buyback yield of -5.5%) — and the lower-priced, small value companies issued far fewer net shares.

Do US companies of comparable size dilute less or more to EM?

No hard data, but it seems share dilution would be directly related to company growth rates. Assuming comparable size, if emerging market companies are needing more capital and thus issuing more new shares and spinning off more new enterprises than their U.S. counterparts, their dilution rates would likely be higher — and vice-versa.

Thanks for the info. The purpose of my question was to ascertain if the high dilution rates were unique to emerging markets, or is it more of a function of them being smaller and more growth related companies, which tend to have higher dilution rates.

[SimpleGift]

Thanks for the info. The purpose of my question was to ascertain if the high dilution rates were unique to emerging markets, or is it more of a function of them being smaller and more growth related companies, which tend to have higher dilution rates.

Appreciate the clarification. Based on the U.S. data above comparing large-cap and small-cap firms, it seems likely that share dilution is more prevalent in smaller, more growth-related companies, wherever they may be domiciled around the world.

Plus, there's little evidence that emerging market companies in general have caught the "buyback bug" so prevalent in the U.S. and developed markets today. In a previous Forum thread, we saw that buybacks make up about 5% of total shareholder payouts in China, India and other emerging markets — compared with 30%-40% of total payouts today in developed markets.

[JBTX]

Stepping back, is this really dilution? I tend to think of dilution as when share are issued at below market value (stock options etc) diluting the equity share of existing holders. If a company issues more shares at current market value, then that presumably is additional funding/capital that should in theory provide additional growth. It is only a bad thing if one assumes the new incremental capital will be invested less effficiently on less attractive projects.

[alpine_boglehead]

Stepping back, is this really dilution? I tend to think of dilution as when share are issued at below market value (stock options etc) diluting the equity share of existing holders. If a company issues more shares at current market value, then that presumably is additional funding/capital that should in theory provide additional growth. It is only a bad thing if one assumes the new incremental capital will be invested less effficiently on less attractive projects.

Interesting point. Theoretically, the newly added capital should make the company more valuable by the same amount of money that was taken in, so even though your percentage of ownership of the company went down, the overall value you hold should still be the same. Assuming that the new issuance was not underpriced, as you say.

But, looking at it from the other side, then how would share buybacks drive up the price? Along this line of thought, that would also be a neutral operation, i.e. the company value is reduced by the money spent on share buybacks.

[SimpleGift]

Stepping back, is this really dilution?

For index investors, it will always be the case that when growth is funded by the net issuance of new equity, the earnings-per-share of the index will grow slower than aggregate index earnings. This will show up directly in the earnings-per-share calculation for each accounting period — and is the mirror image of net share buybacks increasing index EPS growth rates.

However it sounds like you are suggesting a larger view, that net new share issuance can actually benefit index shareholders in the long run, since the new capital (if invested wisely) can help index companies to grow and generate even greater future earnings. Yes, in the longer term this might well happen — even though the net new share issuance is initially dilutive.

But emerging markets haven't yet reached this payoff point, as share counts are still growing faster than aggregate earnings.

[JBTX]

Stepping back, is this really dilution? I tend to think of dilution as when share are issued at below market value (stock options etc) diluting the equity share of existing holders. If a company issues more shares at current market value, then that presumably is additional funding/capital that should in theory provide additional growth. It is only a bad thing if one assumes the new incremental capital will be invested less effficiently on less attractive projects.

Interesting point. Theoretically, the newly added capital should make the company more valuable by the same amount of money that was taken in, so even though your percentage of ownership of the company went down, the overall value you hold should still be the same. Assuming that the new issuance was not underpriced, as you say.

But, looking at it from the other side, then how would share buybacks drive up the price? Along this line of thought, that would also be a neutral operation, i.e. the company value is reduced by the money spent on share buybacks.

One can look at a share buyback as just another form of dividend.

You could assume a share buyback represents a point where additional capital does not lead to incremental returns. Perhaps there is a bunch of cash sitting on the balance sheet, and growth opportunities are limited. In that case excess capital that can’t be efficiently deployed is returned to shareholders, earnings are unaffected, and earnings per share is increased. Just a different way of doing a dividend without implicitly committing to a higher payout ratio in perpetuity.

What often seems to be the case is debt is increased and proceeds are used buy back shares. So net available capital may not change, but the firm is just leveraged more. It could be that the interest expense impact is less than the per share earning increase due to less shares. Return per share is higher, but risk is now also higher with a greater fixed cost burden.

In the best cases, such a swap of equity for debt may be to more efficiently reallocate capital and lock into debt when interest rates are historically low. On the more nefarious side, such transactions are entered into in order to spike EPS and increase executive compensation (stock holdings, options, grants, etc)

Share buy backs are a bit hard for me to conceptually get my head around. On one hand, I can see that they could make sense, and buying shares at a high stock price is essentially a dividend, where some shareholders elect a dividend and everybody else retains a greater equity stake. On the flip side, you would think a company would want to buy their own shares when viewed as priced too low. I have a hard time reconciling those competing points of view.

[JBTX]

Stepping back, is this really dilution?

For index investors, it will always be the case that when growth is funded by the net issuance of new equity, the earnings-per-share of the index will grow slower than aggregate index earnings. This will show up directly in the earnings-per-share calculation for each accounting period — and is the mirror image of net share buybacks increasing index EPS growth rates.

If more shares are now available, isn’t that also reflected in the index? Earnings and price per share may be initially diluted, but now there are more shares in the index...correct?

However it sounds like you are suggesting a larger view, that net new share issuance can actually benefit index shareholders in the long run, since the new capital (if invested wisely) can help index companies to grow and generate even greater future earnings. Yes, in the longer term this might well happen — even though the net new share issuance is initially dilutive.

But emerging markets haven't yet reached this payoff point, as share counts are still growing faster than aggregate earnings.

If share count growth are exceeding aggregate earnings growth, then yes you are correct. If this continues to happen then it isn’t just due to timing/ lag, the newer capital is not being deployed as efficiently and there is indeed dilution.

[Northern Flicker]

For index investors, it will always be the case that when growth is funded by the net issuance of new equity, the earnings-per-share of the index will grow slower than aggregate index earnings.

Actually it depends on how quickly the capital raised is put to work to generate a new source of earnings. A pharmaceutical company using the capital to develop a new medication might have a very long latency from start of R&D until release of the product. A REIT might purchase an existing commercial building with the funds raised and start realizing additional net rental income right away.

[david1082b]

I think most earnings for the UK index are from outside UK. Comparing UK gdp growth to UK EPS growth is not what I would choose. I would compare earnings growth to earnings per share growth.

[lazyday]

Stepping back, is this really dilution? I tend to think of dilution as when share are issued at below market value (stock options etc) diluting the equity share of existing holders. If a company issues more shares at current market value, then that presumably is additional funding/capital that should in theory provide additional growth. It is only a bad thing if one assumes the new incremental capital will be invested less effficiently on less attractive projects.

Maybe it's different uses of the same word, or at least a different emphasis?

In evaluating a single company: If for example a company privately issues shares at a discount, this reduces the ownership per share of a minority passive investor, in a way that may harm their economic interest. Clearly a dilution.

A secondary public offering may also technically be a dilution, but I guess we wouldn't usually use that word?

If we instead are evaluating an entire market, especially if we are comparing EPS growth to GDP growth, then a secondary offering is very much dilution.

[SimpleGift]

Stepping back, is this really dilution?

For index investors, it will always be the case that when growth is funded by the net issuance of new equity, the earnings-per-share of the index will grow slower than aggregate index earnings. This will show up directly in the earnings-per-share calculation for each accounting period — and is the mirror image of net share buybacks increasing index EPS growth rates.

If more shares are now available, isn’t that also reflected in the index? Earnings and price per share may be initially diluted, but now there are more shares in the index...correct?

Yes, there are more shares in the index, but because aggregate earnings are still the same, the earnings-per-share has been diluted — and this apparent growth is of no immediate benefit to the existing shareholders.

Just as, conversely, a reduction in the number of shares due to net buybacks would be a benefit to the remaining shareholders, by increasing their earnings-per-share.

[SimpleGift]

I think most earnings for the UK index are from outside UK. Comparing UK gdp growth to UK EPS growth is not what I would choose. I would compare earnings growth to earnings per share growth.

A good point. Share dilution is not the only reason EPS growth can diverge from GDP growth — a large proportion of foreign revenues can also lead to a disconnect. In the Schroders study in the OP, they had a nice chart of foreign revenues and exports, by country:

• 
  Note: Exports as of 12/16; foreign revenues as of 7/14.
  Source: Schroders

The U.K. was right up there with Taiwan (at right), with more than 65% of corporate revenues from foreign sources.

[JBTX]

Stepping back, is this really dilution?

For index investors, it will always be the case that when growth is funded by the net issuance of new equity, the earnings-per-share of the index will grow slower than aggregate index earnings. This will show up directly in the earnings-per-share calculation for each accounting period — and is the mirror image of net share buybacks increasing index EPS growth rates.

If more shares are now available, isn’t that also reflected in the index? Earnings and price per share may be initially diluted, but now there are more shares in the index...correct?

Yes, there are more shares in the index, but because aggregate earnings are still the same, the earnings-per-share has been diluted — and this apparent growth is of no immediate benefit to the existing shareholders.

Just as, conversely, a reduction in the number of shares due to net buybacks would be a benefit to the remaining shareholders, by increasing their earnings-per-share.

While I agree there is probably minimal short term impact of the new shares it is no different than any influx of capital. The issuance of new debt won’t lead to immediate benefits but nonetheless will increase interest expense.

It is possible that an influx of equity capital could have a short term impact - perhaps paying off high interest debt, or avoiding issuing new debt. Influx of capital could lead to more favorable terms with vendors and purchase of additional inventory. Ability to hire people that are directly needed in the sales or production process.

[SimpleGift]

While I agree there is probably minimal short term impact of the new shares it is no different than any influx of capital.

If we were talking about regular corporations in an economy with normal growth rates, I'd be more sympathetic to your point — that capital from new share issuance (wisely and productively invested) will eventually come to benefit existing shareholders.

But in the fast-growing, emerging economies discussed in this thread, this long-term benefit has yet to materialize — and one wonders if it ever will. We now have over 20 years of data on the aggregate earnings growth of Chinese companies (in green, chart below), compared with their per-share earnings growth (in orange):

• 
  Source: Pieria UK

Obviously, China's headline earnings are growing rapidly, but they are being spread across a shareholder base that is growing even faster — without the "catch up" benefit yet to existing shareholders that one might expect from all this new investment.

I'm not against investing in emerging markets, as I overweight them myself — and while I expect their stock returns to be marginally better than developed markets in the decades ahead, I don't expect returns to match their rapid GDP growth rates.

[JBTX]

While I agree there is probably minimal short term impact of the new shares it is no different than any influx of capital.

If we were talking about regular corporations in an economy with normal growth rates, I'd be more sympathetic to your point — that capital from new share issuance (wisely and productively invested) will eventually come to benefit existing shareholders.

But in the fast-growing, emerging economies discussed in this thread, this long-term benefit has yet to materialize — and one wonders if it ever will. We now have over 20 years of data on the aggregate earnings growth of Chinese companies (in green, chart below), compared with their per-share earnings growth (in orange):

• 
  Source: Pieria UK

Obviously, China's headline earnings are growing rapidly, but they are being spread across a shareholder base that is growing even faster — without the "catch up" benefit yet to existing shareholders that one might expect from all this new investment.

I'm not against investing in emerging markets, as I overweight them myself — and while I expect their stock returns to be marginally better than developed markets in the decades ahead, I don't expect returns to match their rapid GDP growth rates.

I’m not sure what that graph is supposed to tell me. Of course aggregate earnings growth exceeds eps growth. EPS has still increased by a factor of 6.

[SimpleGift]

EPS has still increased by a factor of 6.

Right, which is why we invest in emerging market equities to begin with. But just don't expect them to outperform developed market equities by a huge margin going forward, based on their rapid economic growth rates.

China's aggregate earnings growth increased by a factor of 50 over the past 20 years — but due to massive share dilution, index shareholders only received a small portion of that benefit. That's all this thread is about.

[comeinvest]

I may be wrong, but there seems to be a misunderstanding. My understanding is that aggregate earnings growth is usually - to some extent - reflected in expected per share earnings, minus a correction factor. The studies that show no or negative correlation between growth and returns are based on actual historic returns, with actual valuations at the start and end of the evaluation period. Countries with higher expected returns usually have higher valuations, all other things being equal. The market usually overvalues growth. As a result, countries with higher growth usually have lower returns. However, if valuations are the same, higher growth countries are expected to have higher returns based on most investment banks' models. So the conclusions appear different because of different assumptions on which parameters are held constant.

I did not study how this reconciles with the numbers presented earlier in this thread. But a more sophisticated analysis can be found in many "global outlooks" by the major investment banks. https://www.blackrock.com/institutions/ ... ssumptions shows an example of a model. "Components of Five-Year Requity Return Assumptions", they have quite different numbers for "net share dilution" for US and DM Ex-US. I think I saw bar diagrams showing the return components for US, DM, EM on this site a few weeks ago, but I can't find them any more. Coincidentally, contrary to the common belief that the U.S. is hugely overvalued compared to international, their US and DM total return forecasts are almost the same, after backing out Re-Pricing and Adustments. I have a hard time understanding the rationale for their "adjustments for the different risk-free cash returns between local-currency cash and US cash". How does the cash rate affect returns?)

https://am.jpmorgan.com/blob-gim/protec ... cale=en_US (click "Advisor"; email registration may be required to download) , page 63, shows earnings growth, gross dilution, and buyback assumptions for various DM and EM countries.

Regardless of actual numbers, most models agree that EM have higher expected returns based on current valuations, as growth is higher AND valuations are lower (although slippage / dilution is also higher).

[asset_chaos]

• 
  Source: Yardeni

To ask a question a bit off topic, does this chart show US companies buying back shares in what appears to be an irrational manner? There seems to be large buying of shares up to 2008 when share prices are high or rising, then lots of share selling as share prices plunge in the financial crisis, then more buying as share prices go higher and higher. I'd have thought corporate treasuers would have wanted to issue shares when prices were high and buy back shares when prices were low. Instead it was the opposite. Or am I misreading the graph? I can imagine that in the crisis they may have felt compelled to raise money in any way possible, including selling shares at whatever prices they could get, but why buy at high prices?

[comeinvest]

• 
  Source: Yardeni

To ask a question a bit off topic, does this chart show US companies buying back shares in what appears to be an irrational manner? There seems to be large buying of shares up to 2008 when share prices are high or rising, then lots of share selling as share prices plunge in the financial crisis, then more buying as share prices go higher and higher. I'd have thought corporate treasuers would have wanted to issue shares when prices were high and buy back shares when prices were low. Instead it was the opposite. Or am I misreading the graph? I can imagine that in the crisis they may have felt compelled to raise money in any way possible, including selling shares at whatever prices they could get, but why buy at high prices?

Excellent observation. The graph looks similar to that of a highly leveraged investor, who receives margin calls in times of distress, resulting in a buy high / sell low pattern. The net return from that "trading" pattern must be disastrous. Maybe it doesn't show much in overall stock market performance because the capital used for these trading activities is small compared to the operating capital. Also, maybe that is one of the reasons why companies with low leverage have higher risk-adjusted returns?
Another explanation might be the lack of an alternative, "better" use of cash, and/or the still relatively favorable equity risk premium because of low interest rates on debt.