Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
By Marc Robins For those of you suffered through [Part 1], congratulations! You’ll be pleased to know, that you are well ahead of the rest of the class by preparing in advance for next Friday’s quiz. (Ian, I know you’re a special student but can gain extra
By Marc Robins
For those of you suffered through [Part 1], congratulations! You’ll be pleased to know, that you are well ahead of the rest of the class by preparing in advance for next Friday’s quiz. (Ian, I know you’re a special student but can gain extra credit points by staying after class and cleaning the board erasers.) All kidding aside after re-reading the first part in preparation for this next section, I noted there was a lot of material covered and probably too much repetition. The section might have been better titled, “Like Teaching Kama Sutra in High School Health class: Too much, too fast!”
For the detention students who missed the last section, you missed a lot of fun. No, not really. We covered a lot of material…a little history about the market, the roots of investment contrarianism, a boatload of personal data and experiences and possibly some worthwhile observations. This was all targeted to convince readers that the next major move for small- and micro-cap should be a roaring, secular rally.
Before we launch into the meat of formal comments, I would like to convey (for those of you who know me, the term, “convey”, in ‘Marc Robins’ parlance’ means “tell another personal story that if we’re lucky may be tangential at best to the main point.” Believe it or not, this one has relevance and might prove interesting.)
Convey (Read: Watch-out, Long story ahead) Over thirty years ago, I was escorting one of my very good friends/clients, Jack Weaver, around some of Portland’s and the Pacific Northwest’s more interesting companies. Jack at the time worked at The Pitcairn Company outside of Philadelphia and was fortunate enough to manage the “school fund” as well as the “Church Fund.” Both accounts focused on quality, growth ideas (Can you believe that I use to traffic in quality/growth equities? Where in my career did I turn “left” just to follow microcap “cats ‘n dogs?”).
We had had some great experiences together. One of the first ideas that we both bought together that worked was Nordstrom convertible bonds. Remember, this was back in the very early 1980s and “breaking out” of the Northwest meant to the three Nordstrom brothers locating a store outside of Oregon, Washington or Utah. Yes, it was before their first California store (downtown San Francisco) just prior to the Companies great growth spurt and heightened Market following. It was also the era where the “school fund” and some personal accounts started dabbling in Precision Castparts (PCP). I get reminded of their $1.00 to $18,300.00+, long-term advance in the stock every time I contact a few of the original investment team who still reside around Philly.
Well on a lark and to fill in some time, I decided that we should visit Hyster headquarters and Bill Fronk, CEO. Hyster might not be considered a “true” growth story but I was convinced it was a value and indicators were that a turn in the economy was upon us. Hyster (HYST) was really more an industrial “special situation” and I convinced Jack that a forklift manufacturer could be “Special” and worthy for consideration.
But to understand Hyster, one needs to understand the CEO. To say the least, he was a tough operator! (I’ve finished the book, The Admirals: Nimitz, Halsey, Leahy, and King. This is the story about the first, 5-Star admirals that won the sea war for the USA during WWII. I imagine Fronk being the corporate equivalent of “Bull” Halsey…little charm, no dramatics, just forceful and productive action. A great operator.) Fronk and his team were always striving to improve Hyster’s products, market position, and profitability. This guy never held any news back (as long as it didn’t get him in SEC trouble.) He certainly never “sugar-coated” any message. In short, he was a tough bastard!
So, Jack and I went to the Lloyd Center office headquarters and I got the overall business description. Then Fronk gave us the unvarnished news regarding the near future. Indeed, the next day before the opening, the Company was announcing the closing of their Portland Plant (the original manufacturing facility), their Belgium and Australian facilities, the closing down of an ancillary manufacturing plant and their R&D facility and moving most everything except the headquarters to South Carolina or Indiana. Essentially, the news made it all look the business was falling into a huge, black hole. The turn, economically, could not really be counted on, but neither of us was prepared to hear this kind of news. When we started the meeting, we both understood the earnings power of the Company could ultimately be $4 to $6 per share for peak earnings. By our rough guess, earnings power had been boosted by these most recent moves to $8 to $9 per share.
Jack and I staggered over to the elevator after the meeting. We were both stone quiet. When the doors closed, we started to talk over the “efficiency steps” we had just heard about and tried to relate this back to the soft, US economy and whether things were really improving (In those days, the trend in forklift sales was a very good leading indicator regarding the turn and direction of the economy as a whole. We were deciphering whether the economy was falling back into a hole or if management was tired of dealing with expensive municipalities—specifically Portland–where they were based. These moves were preemptory.).
But by the time we rode from the 15th floor and utter despair to the lobby, we convinced ourselves that maybe the news was a perfect entry point for the shares. The market would obviously crack the stock…then trading about $27 per share at the close. Investors overall would not truly understand why the steps were being taken (certainly cost-cutting but also totally eliminating secondary and less efficient operations for the sake of future profitability and growth.). Upon the morning’s market action, I remember witnessing the shares slice through $23 and receiving a “Buy” order for a half position-sized quantity trade in the very low 20’s.
Now we are getting to the relevant part to this story.
Yes, Jack and I changed our opinion from a “Holy Smokes, what a disaster!” to “Hey, this could be the buying opportunity of a lifetime!” But wait! There’s more! It wasn’t a quarter later that the operating results for Hyster turned positive and started to grow. (I’m sorry for the hazy details…this is not a “commissioned” piece of work but a “reminiscence”…so, my best guesses are going to have to suffice rather than precise details.) Hyster shares began to rise.
Now scroll forward to the following August. I was in Alberta, Canada and happened to call into the office just to check-in. Word had crossed the local news that LBO investor KKR, was making a $60+ bid for Hyster. It was truly notable since the offer was the first time the “buy-out” operation had interest in a cyclical operation as an investment. Aware of my research on HYST, a local (Portland) business reporter wanted my thoughts on the unsolicited bid. The question, “what do you think of the offer?” was the overall gist of the story. My reply, “That this was a low-bid. If HYST was going to be bought, it should happen at a much higher price.” Low and behold, the founding family bought-out the remaining shares of the operation they did not own, out-bidding KKR at $72.
Why the HYST story? It was a stone-cold, dead business that nobody would touch priced in the mid-$20s. Yet, the story turned, better operating numbers were produced, and the underlying value of the operation was revealed and pursued. One beholder thought Hyster was worth more than another and certainly more than the market and the stock market did what it is supposed to… a higher (more appropriate) value was “outted” in the end.
In the sense that “I’d rather be generally right, than specifically wrong”; Hyster did go on to prove my predictions of ‘unimaginable wealth’ in a flow of earnings. One of my neighbors was a tax person deep in the bowels of the operation. He came over one evening to ask my opinion about whether-or-not to buy a greater number of incentive warrants or options than allocated to him just as an employee. He privately showed me performance over the recent past (this happened about two to three years after ‘ESCO’ bought Hyster.) To say the least, earnings were proving far better than my guestimates back in 1982….Something like $6.00 going to $8.50. I said, “Of course, BUY!” and he departed.
A couple more years passed, I ran into this neighbor at a coffee house or the Friday Professional wrestling bout at the Portland Armory. I asked if he had taken chance on the option offering. No! Oh, what happened to the stock and where did earnings come in? Well, he had made a small fortune just off of his “free” allotment made available to employees, but the response answered my question. I didn’t chide him for not taking the chance on the extra options, and I faded into the night smugly feeling warm and fuzzy being vindicated for the research work performed back so many years ago.
If one wants to discuss stock/company renaissance, or better yet, a contrarian resurrection from the depths, then the conversation has to include the two-decade old story of American Pacific, Co. (NASDAQ: APFC–$11.87.) This Company is still around today, unbelievably, and investors can actually check out the Yahoo price graph to follow-along with my relating of this old story.
From 1988 to 1994, I was managing money. The idea of APFC was proffered as a proverbial phoenix rising from the ashes… the truest of contrarian stories. This Company was literally re-emerging from the ashes and was priced as if it would never emerge let alone survive.
It so happens that this operation produces very high-quality ammonium perchlorate…the chemical that produces and supplies oxygen to solid-fuel rocket engines when in space. So immediately, one should think: Space Shuttle…NASA; ICBMs….Air Force or Navy; maybe Cruise Missiles…DOD. In the 1980s, they had a ready market for their primary chemical. That’s the “good” news. The “bad” news is/was that there happened to be an old and leaky Mountain Fuel gas pipe line buried directly under the plant. Sure enough, where did the pipeline happen to develop a small leak? Right under the AP plant. Where did the gas escape? Right up into the manufacturing area in the plant itself. You get the idea…Ya, an explosive opportunity.
Inexplicably, some sort of spark occurred, which ignited the misplaced gas, which started a chain reaction given the presence of AP, which created a true disaster committing massive destruction and devastation that “wriggled and jiggled and tickled inside her, I guess she’ll die.“ (Oh sorry! Got carried away.) Unfortunately, I remember roughly a half-dozen individuals that died from the fall-out. This explosion was not the kind “disaster” often exclaimed as hyperbole you hear from Wall Street types. No, this was an incredible and awesome (real meaning of the term used here) catastrophe. Check out the video..
Not only did the explosion leave nothing but ruble and ashes where the APFC’s facility formally resided, it created $80 million of collateral damages to the surrounding community of Henderson.
I invested in and made a pile of money in APFC shares from 1989 to 1992 (I sold the entire position precisely on February 29th, 1992). From $2.00 to $40.00 in three years, the run was remarkable. It was the very reason and the financing factor to my creating The Red Chip Review. Here’s why I plunked down the money in the first place on such an outlandish story and the incredible supporting factors that helped springboard the share price.
What most investors missed was a special visit to APFC by potentates right after the explosion. I like to characterize it like this: APFC having no real operating facility rolled-in a mobile home for an office to the disaster site. About a day-and-a-half later, the doorbell rang and three men appeared introducing themselves as Mr. NASA, Mr. Thiokol and Mr. Bank. Mr. NASA says, “We need your AP for the Space Shuttle program. Mr. DOD isn’t here, but he needs your AP because it is so pure that when fired from a missile, it leaves no smoke trail, hence no radar tracking signal. So, I’m giving Mr. Thiokol an $80 million contract for your AP. They are going to write a contract with you to supply the AP for the Shuttles solid rocket motors. And with the purchase order, you can go to Mr. Bank here and secure the necessary funding to rebuild your plant.” And this might be a Tolkienesque approach to relaying the story, but its close enough, kind-of accurate and works to help move the story along.
Within a couple of years (I think the explosion was May of 1988 and the new plant was essentially operational by 1989), APFC was generating cash flow, paying back the debt and “digging itself out of a hole!” (Oh, a clever funny.).
Around late 1999, there was a rumor that APFC was broadening its chemical offerings by adding Sodium Azide to its production list. For those not quite old enough to remember the early 1990’s, cars at that time only came with seatbelts and didn’t really have ‘airbags.’ In the very early 90’s and after the introduction of the steering wheel airbag in the late 80’s, there was a deluge of excitement about employing bags on the front passenger side of the car, on the interior sides of cars, backseats, bumpers, engine compartment, etc. Ha! Sodium Azide was the magic chemical that just explodes perfectly, generating volumes of gas at an eyeblink pace, filling the bags sufficiently to counteract the collision and absorb the shock of a body’s impact.
For that same crowd unfamiliar with cars that didn’t sport airbags, you also missed the really wonderfully entertaining, “Drivers Ed.” movies shown in sophomore Health. They were sure to get at least a couple of classmate cuties to heave given the blood, gore and guts. My particular favorite was the pin-headed man, caught in a head-on collision in a ’39 Hupmobile. Let just say that he no longer had to worry about the size of his head, rather he had to worry about modeling a noggin after shaving with a pencil sharpener.
Anyway, the demand, and projected demand, for sodium azide had a trajectory of an Atlas Rocket moonshot.
Remember the explosion?! Remember how APFC should have changed its name to American Rubble?! Well by 1991, the problem with cash flow, even earnings, was a distant memory. Not only did the AP chemical plant work like a charm, but the production and sale of azide was now contributing to the story and Company fundamentals. They began to introduce another chemical, Halotron, which had several benefits over the Halon emergency fire extinguisher. APFC seemed well on its way.
I remember a money manager luncheon given by the Merrill Lynch Chemical Analyst. While the trust and bank cadavers were wolfing down their free meals, the lecture focused on DuPont, Monsanto, Union Carbide and the like (real exciting). As soon as the “outpatients” left to punch their respective time clocks, a few of us renegade investors asked “What do you really like and are buying for your own account?” “Why,” the analyst answered us more adventuresome types, “American Pacific!”
Typical of Wall Street: When the stock is a knockout value…ignore the name. When the shares rise to $14.00 per share, buy it for your own account. At $20 and there’s a whiff of a deal, recommend it.
I vividly remember getting a call from my ML coverage broker the morning of the new, Merrill Lynch recommendation. Great guy! I’d been telling him to buy APFC for a year or better. When I answered and learned the news, I said, “See Tom, I’ve been telling you to get involved.” His response,” Ya, but it’s going to take Merrill Lynch to move it to $40.” Like a doubling of the share price provided a far better return than a 10-bag (or 20-bag) gain. “Oy!!!”
This is a fine mess we’re in, Ollie. So, why Hyster? Why APFD? And, why now? I thought a little personal investment history would help set the stage for my first and most important argument as to why this micro-cap market mess reverses. We need to discover a catalyst, or a series of catalysts, that shall take place and foment a dramatic rise in prices regarding the collective micro-cap and small-cap universe? The next question that needs addressing is, ‘whether the mechanism is sufficient to catalyze this trend well beyond that represented by a mere “bounce” in prices? Indeed if you watched the ‘Pepcon Explosion documentary in HD”, you’ll understand that we need some 55-gal drums to go off first in series before the cataclysmic denouement. To that end, it all starts with relative (and in this case, absolute) value.
Incredible value. As we described in the first section, the micro-cap equity arena has been shunned by market makers, brokers and even the regulators. So in a nutshell, one can generalize that the individual stocks are not only unknown, they are incredibly inefficiently priced. To translate, they are, as a class, woefully undervalued. This didn’t happen overnight but has occurred by degrees during the last three decades.
The second facet under this heading is that the major headline news during the last year to 18 months has been dismal. That: A) the country’s economy is in a “worst since the Depression” slump and that no amount of Government stimulus seems to improve the overall performance numbers; B) the economies of Europe and Japan are also moving backwards and; C) China is not without its economic concerns. From an individual corporate standpoint, US corporations are not performing all that well in this environment. Despite all the diversification into other geographies, Europe is weighing-down major entity returns, for all of China’s, it is doing little to boost domestic fortunes….
Juxtaposed to this negative news is the clear message that we (some nebulous, all-inclusive term that seems to mean everybody but especially incorporates “government”) need to support small companies because they are the engine of growth. So even in this dismal economic environment, there are those entities, small but also large, that are doing well because they are tapping markets, have developed technology or have distinctive products that have real appeal.
The third facet is that Corporate America has one of the most incredibly strong balance sheets in the history of industrial America. Although the big corporate brethren are “muddling through,” they have greatly improved their balance sheets and financial wherewithal.
With that said, if I was a big-cap corporate CEO and had to again face my shareholders with paltry increases, or even down, operating results as I face a wholly lackluster world economy, what might be my salvation strategy for survival? What could I do to show investors I’m not just getting a fat paycheck for the sake of showing up? The answer is exactly the same as its been over the last century….buy some company that provides a new, innovative product, is growing more rapidly because it has a better product or brand, solidifies the buyer’s market…. than my own business and that the bigger company can roll-out in a far more ubiquitous fashion.
As I’m writing this tome, Starbucks (SBUX) announced that they bought another tea company Teavana (TEA). They have a well-established tea brand, Tazo, which they have nurtured for years. But think about their situation: SBUX has at present deluded everyone they can into believing their burnt, over-priced coffee is what consumers need in the morning. They’ve established just a reasonable position in tea offerings—what might be considered a normal slice of revenues given a “coffee shop” operation. But now are desperate to add an entirely new line of tea beverages to better attract a new cadre of consumers to augment the horde of coffee-drinking regulars.
Another very recent example is ConAgra (CAG) announcing that it is buying Ralcorp Holdings (RAH). The target is the nation’s largest supplier of high-quality private label cereal, producing both ready-to-eat and hot cereals. In addition, the extended product line includes organic cereals, snack mixes, cereal and nutrition bars, and other innovative products.
Ralcorp, with sales over $4 billion, will add significantly to ConAgra’s total business. Firmly establishing the acquirer as the largest private-label packaged food business in North America, ConAgra’ combined sales will be over $18 billion and it is paying Ralcorp stockholders $90 per share, a 28 percent premium over its previous closing price, to close the transaction.
This above-described flat or no-growth outlook is enough to force the strictest of operations into broadening their perceived scope of possible new business opportunities. Think of Disney (DIS). If Walt was still around, that company would never have ventured outside of Disneyland and “Snow White.” It required new management (Eisner) to create or purchase Buena Vista Productions, Touchstone, to buy Pixar and most recently, to acquire LucasFilms and its single genre. This ability and willingness to expand beyond the old, evergreen cartoon movies as their luster dimmed, is a perfect example of a company expanding into new genres (new business avenues) by adding different production companies. The same goes with US businesses of all kinds.
My examples involve larger-sized acquirers and targets, but as company managements gird their loins to face the reality of the next four years and to move decisively beyond their humdrum operating pace, this new round of merger activity will span all market cap ranges.
The stage has been set for this reversal. Think of it in terms of a forest fire. Simple chemistry explains that you need heat, oxygen and fuel to start a fire. With forest fires, there is plenty of oxygen. We’ll talk about the igniting heat in just a minute. But the amount of fuel, that makes the difference between a fire, barn burner and the Tillamook burn.
Now I’m sorry for the characterization, but think about the fuel situation readily available in the financial markets. Fuel in this case, if you haven’t guessed, is money supply. The country is experiencing a monetary flood by the Federal Reserve unprecedented compared to anything in recent, or historic, experience. Indeed as long-time manager Bill Corneliuson characterizes the flow of funds, “Not even during the time of the Roman Empire was there monetary expansion of this magnitude!” Translated, despite the poor employment numbers and the very poor GDP outlook, the flood of money being shoveled into the market should keep interest rates low and buoy financial markets. That means an over-abundance of fuel.
So unlike the forest fires in the eastern Oregon, Washington or even Idaho, things can get really hot and spread over 10s, even hundreds of thousands of acres. But the underbrush is very limited unlike the forests west of the cascades. When there’s a fire, it can amount to a Tillamook Burn.
So, we have fuel, now we need the ignition.
Well, the strength of Black Friday, Cyber Monday, the entire weekend of retail sales, the strength of Hollywood’s box office activity, the overall prospects for Christmas, and this against the backdrop of slightly better economic activity: all of this provides better evidence that the economy is slowing wending itself up out from its depths. It is these kinds of signals that will help strengthen business leaders out of the “hand wringing” mode and into more aggressive action. Business has been reeling under the weight of the poor economy, greater taxes and fees, more regulation for four+ years. It is the natural tendency of humans, under defensive pressure for that period, to want to go on the offensive. Although the conditions of the economy are perfect, I think that we are not beginning but witness the belligerence emerge. Investors are tired of being tired.
We tend to forget how powerful acquisition frenzies can be and to what extremes they may go. There have been two specific periods such as these of practically unbridled, buy-out fury in modern times: The 1960’s when acquisitions were completed, mostly on a friendly basis, for the purposes of corporate diversification. If you remember your MBA finance courses, this was the period that helped to form “modern” portfolio management theory as a financial theory and way to teach that portfolio management, rather than the actual purchasing of businesses, was a more neat, convenient and expeditious approach to achieving portfolio nirvana.
One of the big advantages that corporate merger activity enjoyed back 5 decades ago was that exchanging stock between companies and shareholders…using the “pooling method” of accounting almost exclusively…was a more legitimate way to transact an acquisition. Tax and accounting rules were more lax about the use of this payment method and it certainly made the math/earnings/PE calculations all work out in a much easier fashion. When this accounting/tax rule was tightened down, it really diminished the activity level of mergers.
Also, the use of transactions between wholly unrelated operations for the benefit of diversification was typically more common among larger companies during the era. Analysis of the investment banking activity during the 1960s shows that the fraction of single business companies of the Fortune 500 list dropped from 22.8% in 1959 to 14.8% in 1969. This decline resulted directly from increased buy-out activity.
The 1980s introduced a new flavor of merger activity. This was distinctly a period of unfriendly takeovers and mergers by corporate raiders and specialty funds. Most of us just remember the negatives that were highlighted by the excesses which occurred in the latter half of the decade. The man on the street remembers the equity asset bubble and the crash of the 1980s, the collapse of saving & loans in the early 1990s, as well as the trials of Boyd Jefferies and Michael Milken, etc. At the same time, they tend to forget the untold wealth that was fostered , the upstart and launch of multiple new industries and technologies (cell phones, information industry—PCs and software, disposable cameras, soft bi-focal, disposable contacts, nanotechnology, HD television, Prosaic and much more), as well as the financing of a multitude of new industries.
So, our transferring this idea of big fish eating the little fish to the small- and micro-cap equity arena answers the first question: What is going to ignite this renaissance in micro-cap equities? Value! Next, what are going to be the factors that help prolong this initial merger activity into a long-term trend?
Here ends “Part 2” of the Emerging Micro-Cap Era.
In the next section, we are going to discuss the factors that we believe will help provide the long-legs to the micro-cap rally.
 I should have known that this stock story had been blessed by the CFA Gods because during my educational experience studying for Year 1 of that process, Hyster Co. was thoroughly described in one of the text books, On Competition, by Michael Porter. At the time—the early 1980’s, Porter used Hyster as the example of a non-dominant industry participant in the forklift truck arena but the industry leader in profits and returns. They literally blew the normal standards of performance out of the water when comparing the competitive advantages of Hyster out-producing those of all the “also-rans,” including Toyota.
 After I wrote my initial report, this was well after the Jack visit and I thought I had a few kudos points stacked in my favor. I invited Bill to our offices for a very informal sandwich lunch with brokers and local managers. I invited Mike Cieply of Forbes as well. Instead of being pleased, Bill got up, went to the door, and just about walked out of the building. Bad blood between Hyster and Forbes due to prior articles written had poisoned the relationship between the two companies. During those years, the press (at least Mike and Forbes) had real gentlemanly manners: Mike suggested he go elsewhere for lunch (having flown from LAX for the meeting.) The presentation was saved and we (Mike and I) caught up about the presentation after lunch and the formal comments.
 Go ahead and believe the prima facie numbers from the Government Departments, but if you do any investigative work the numbers are “cooked” and revisions are rampant as they are ubiquitous.
 I am a very big believer in the “trickle-down” theory of wealth. I know that I tip a whole lot less when I’m worth less. One thing I like to do is go to the service trades and retailers (coffee shops, etc.) I use and am very familiar with and ask about their tip experience….It’s not improved. That said, I truly believe that part of the economic malaise that we’ve experienced to date is due to the point that vast wealth has been destroyed since 2008 and the obverse, the massive creation of wealth, has yet to occur.
About Marc Robins: Mr. Marc Robins is a Managing Partner and Founder of Catalyst Financial Resources, LLC. He is also employed as a Preisdent and Director of Research at The Robins Group, LLC. Prior to these positions, Mr. Robins was the Founder, Editor-in-Chief at the RedChip Companies, Inc.. Mr. Robins resigned from this other post as of November 22, 2002 and has since moved to full-time positions at Catalyst Financial Resources, Crown Capital, LLC, The Robins Group, LLC and Crown Point Group, Ltd. Prior to founding the RedChip Companies, he was co-manager of the WestCap Small-Cap Portfolio for Capital Consultants, Inc. in Portland Oregon. Mr. Robins has previously held positions of portfolio manager, and directors of research at several Portland, Oregon-based investment firms. Mr. Robins was the President of the Portland Society of Financial Analysts. He served as a Director of FreeRealTime.com Inc. since August 2000.
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Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
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