Value investors believe that owning a stock is owning a slice of the underlying business… but this isn’t always true.
Innovative corporate forms such as Special Purpose Vehicles (SPV) and (Variable Interest Entities (VIE) allow businesses to raise capital through equity issues while substantially limiting the rights of equity holders.
And much of the time, shareholders are none the wiser.
For example, Chinese companies that operate in sensitive industries, such as Alibaba and Tencent, are not allowed to have foreign shareholders. They work around this problem by creating shell companies, which are granted a contractual right to a defined portion of the main companies’ profit and control.
So if you buy BABA or Tencent, you have no ownership interest in the “real” company — you only have an ownership interest in a shell company whose only asset is the contracts which give it a right to share the profits in the underlying business.
These arrangements are not obvious unless you read the S-1 forms filed with the SEC during the initial offering of the stock. 10K annual reports will often allow you to deduce this ownership structure, but it is generally not explicit. Indeed, under both US and international accounting principles, an SPV or VIE is allowed to consolidate its financial statements with those of the “real” company / underlying business.
And it’s not just Chinese companies who are using innovative legal structures to dilute shareholder interests. Buying a share of Rocket Companies (RKT), for example, does not give you an equivalent ownership interest in Rocket Holdings (which owns the organization’s primary cash generating businesses: Rocket Mortgage).
Rocket Companies only has an 8% economic interest in Rocket Holdings, with the rest being owned primarily by founder Dan Gilbert. In other words, each RKT share represents only a slice of a very small slice of the total business.
For some investors, this might not matter much, But for value investors who base their decisions on what portion of cash flows they are entitled to as shareholders, these legal structures can make valuations difficult.
If you scrutinize RKT’s annual and quarterly reports you will notice that earnings attributed to non-controlling interests are subtracted out before the calculation of earnings per share.
On the other hand, the cash flow statement does not receive a similar treatment. This means that RKT’s EPS and P/E ratios accurately reflect the “piece of the pie” belonging to equity shareholders, but that its reported cash flows and retained earnings require adjusting if you want to consider them from the shareholder’s perspective.
