Dilution levy – Why investors should focus on the detail of earnings per share growth

It has become something of an investment cliché that there is no correlation between long-termg GDP growth and stockmarket returns. In other words, just because a country’s economy is booming, it does not automatically follow its stockmarket will. By the same token, just because an economy is only ticking along, it does not mean you cannot make good money investing in its companies.

What we hear a good deal less about is why that should actually be and so it was interesting to read the thoughts of Derek Minack – formerly a strategist at Morgan Stanley and now of Minack Advisors – on the subject in one of his recent ‘down under daily’ notes. The crucial element in all this, he postulates, is not growth in corporate earnings but growth in earnings per share.

There is no getting away from the fact that corporate profits are correlated with economic growth. To illustrate this, Minack points out how companies in China have grown much faster than their US counterparts over the last 20 years. but he also shows that, in China, growth in earnings per share – what we actually receive as investors – is far slower than headline profit growth.

Source: Datastream; Minack Advisors 14th October 2013

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

Why is this? The reason appears to be because, despite the quick pace of profit growth in China, the equity base – in other words, the number of shares supporting these profits – grows almost as quickly, diluting shareholder returns. This is not a coincidence. Looking across several different geographies, it turns out the dilution effect is directly related to the speed of economic growth.

The faster a country grows, the more new companies appear and the more new shares are issued. Profits are obviously growing but these profits are spread across an equity base that is expanding almost as quickly. As such, the earnings growth per share – the number investors should care about – is held back.

Urbanisation is just one of the huge investment themes playing out in China but, as an investor, you enjoy absolutely no benefit from that unless you have a stake in a company that can both capitalise on this growth and, crucially, do it without the need to issue disproportionate amounts of new equity. “China’s high earnings dilution reflects both a poor allocation of capital and its focus on capital-intensive sectors,” observes Minack.

In equity markets, investors can often become so dazzled by the ‘bright lights’ of ideas such as urbanisation that they fail to focus on the details – most importantly, what, if anything, ends up flowing down to them. the us may be a lower-growth market but it has historically offered better growth opportunities for investors.

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