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I want to warn you about stock splits today – and to save you from getting bamboozled the next time a company splits its stock, like Netflix (NASDAQ: NFLX ) is scheduled to do next week. If you have ever gone grocery shopping, you might think you have a good understanding of stock splits. For example, I’m sure you have noticed that four one-quart containers of milk will cost you more than a one-gallon container. The milk company is able to create value by dividing the original gallon into smaller containers. But what works in the supermarket does not work on the stock market, despite the fact that many investors behave as if they believe it does. They become elated when they hear that a stock they own is about to split, because, like in our milk example, they believe that the sum of the parts will be worth more than the whole. Or they decide to buy into a stock because it is going to split, believing, again, that four quarts is worth more than one gallon. I have always found this behavior curious. After all, what’s the difference between owning 100 shares of a $100 stock and 200 shares of a $50 stock? There is no difference. Your total investment is worth $10,000 either way. The only reason to think otherwise would be if you believed that a stock would appreciate at a faster rate after a split than it would have without a split. However, there is no evidence to support this line of thinking. When managements are asked why they split their stock, they inevitably say that the price of the stock had gone up too high, making it unaffordable for many investors. By saying this, they are implying that there would be greater demand for the stock if only the price were lower. Those of us who studied Economics 101 would agree that for most goods, there is a relationship between price and demand. In general, the lower the price, the greater the demand. However, stocks are not like milk. You can’t create value out of stocks simply by dividing them into smaller units. A stock split changes the price per share, but it does not change the price of all the shares in aggregate. In other words, a stock split has no impact on the company’s market capitalization. If the company were in play, do you really believe the acquirer would pay a larger premium simply because the target split the stock? Of course not. Having said that, I must admit that there are times when stock splits make sense. For example, several decades ago, before there were discount brokerage firms, trading costs were extremely high. Furthermore, investors paid a penalty if they bought (or sold) less than a round lot (i.e., 100 shares). As a result, there was a significant monetary incentive to trade at least 100 shares at a time. That’s no longer the case. Trading commissions have been driven down significantly. If you can’t afford to buy 100 shares of a $1,000 per share stock, there is nothing preventing you from buying 50 shares or even 10 shares. For that reason alone, there is much less of a need for corporations to split stock. So are there any good reasons for a company to split stock these days? Sure. A stock split would make sense if the stock price were so high that even one share were unaffordable. Berkshire Hathaway Class A (NYSE: BRK.A ) shares sell for more than $200,000 each. There aren’t many investors who can afford that. It would certainly make sense for Berkshire to split the stock. The problem is that Warren Buffett, the chairman and CEO, vowed long ago to never split the shares. Yet, at one point, he realized he had a problem. So in order to avoid breaking his vow, he simply created a new “Class B” (NYSE: BRK.B ) type of share. For all intents and purposes, the creation of the Class B shares was equivalent to splitting the stock. Here’s another good reason for a split. Apple (NASDAQ: AAPL ) initiated a 7-for-1 stock split in June 2014, when the stock price was near $700 per share. That’s nowhere near Berkshire territory. Most investors could easily afford to buy 10 or even 20 shares of a $700 stock – so why the split? The answer became clear a few months after the split, when Apple was added to the Dow Jones Industrial Average. Unlike most market indexes, the Dow is not capitalization-weighted. It is price-weighted. In other words, the higher the price, the greater the impact on the index. There was no way the folks at Dow Jones were going to include a $700 stock in the index. By splitting the stock, Apple brought the stock price down to a level that was comparable to several of the Dow’s other components. The split made Apple eligible for membership in one of the most prestigious market indexes. Finally, there is one other valid reason why companies might want to split their stock. A stock split can be an effective way for management to signal its optimism to the market. It’s one thing for the CEO to state that he or she is bullish about the company’s prospects. It’s a completely different thing to actually signal that optimism by splitting the stock. In this case, a stock split is like putting your money where your mouth is. Management would not be likely to initiate a split if it thought the company was about to run into a rough patch. Here’s my advice on stock splits. Don’t buy a stock just because the company announces a split. A split might cause a brief rally, but there are more important factors that will have a stronger impact on the stock price over the long term. Perhaps this is best exemplified by recent events at Netflix. The company announced a 7-for-1 stock split right after the market closed on June 23. Not surprisingly, the immediate reaction was euphoric. The stock surged significantly higher in after-hours trading. Yet, by the end of the following day, shares of Netflix were trading lower, and they have continued to drift lower ever since. It turns out that Carl Icahn had liquidated his entire position in the company, suggesting he thought the shares were no longer undervalued. That’s more important than how many quarts are in a gallon. Scalper1 News
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