Why Shareholders Should Cheer -- Not Jeer -- This Company


Source: 401(K) 2013.

A piece of stock represents ownership in a business. How much ownership you get for each share of stock depends entirely on how many shares there are. If there are 100 million shares of stock outstanding, one share isn't worth much. But if there are only 100 shares, one share can be worth quite a bit.

We've grown accustomed to the idea that the existence of more outstanding shares is always bad, while the existence of fewer shares is always good. But this couldn't be further from the truth. In fact, some companies can make shareholders wealthier by issuing new shares of stock.

This company sold 15 million new shares
This week, business development company Fifth Street Capitalissued 15,000,000 new shares to sell at $10.31 each.

News of the transaction sent its stock down by more than 4% at the opening bell. Investors may have gotten ahead of themselves, however -- this new stock sale was good!

Fifth Street Capital reported a net asset value of $9.90 per share as of the last quarter. By selling stock at $10.31, it expanded its balance sheet without diluting the holdings of current investors.

Fifth Street Capital will likely receive right around $9.90 per share after factoring in underwriting fees. It's a wash -- new shares have not in any way diluted the holdings of existing shareholders. Rather, Fifth Street Capital was able to use its premium share price to raise cash as it enters its busiest time of the year: the fourth calendar quarter.

Other serial stock issuers
Business development companies (BDC) are constant share issuers by design because they cannot retain earnings to grow. Virtually all earnings have to be paid out as dividends to avoid income taxation.

Thus, the only way for a BDC to grow is to issue shares to the public, hopefully at a premium. In August, Main Street Capital used its high share price to sell 4.6 million shares at $29.75 per share. The company last reported a net asset value (NAV) of $18.72 per share prior to the secondary offering.

All in all, Main Street Capital was able to raise $131.4 million net of fees and grow potential NAV per share to $19.87 holding all else equal. Just like Fifth Street, Main Street Capital also saw its share price sink by 4% when it announced a secondary offering.

Not all BDCs get walloped when they issue new shares. Prospect Capital is able to issue new shares -- and avoid headlines -- by making quiet use of so-called "at the market" stock sales. Keeping new share offerings hush-hush until the end of the quarter allows Prospect Capital to trade at a near-constant premium to book value while growing its balance sheet day-by-day.

There's only one caveat
The only time new share issuance dilutes the value of existing shares is when the company cannot generate the same or similar earnings with new capital as it can with its existing capital. That doesn't appear to be the case for any of these BDCs.

The truth is, short-term movements from secondary offerings are largely the result of panicked investors and fast-acting traders. Ignore the noise. If you liked the stock before the secondary, you should love it after.

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Originally published