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David Gardner series: Stock Splits

"When do you think RuleBreakerStock.com will split?"

The question is often asked: on our discussion boards, on investment TV and radio shows, maybe at your next cocktail party. It is asked by people who actually mean, when you boil it down to the subtext:

"Do you think RuleBreakerStock.com [a generic stock I'm making up] will go up?"

That's what they mean.

For them -- for many people -- asking when and if a stock will split is synonymous with asking if the stock is going to rise, is going to be a good investment. And yet there is virtually no connection, and certainly no guarantee. Asking if a stock will split is NOT asking if it's going to be a good stock. For this reason, I consider stock splits to be perhaps the MOST COMMON CONFUSION for equity investors today. And that's why I wanted to start my David Gardner series with that.

Contents

The Basics

Companies simply decide from time to time to reduce their share price and increase their number of shares available so that, as an example, they'll issue a 2-for-1 split that halves their share price and doubles their shares outstanding.

No change in value.

The market capitalization, the company's total value, of a stock is simply the shares outstanding multiplied by the share price. Thus, if you split the stock, you simply have that many more shares and that much lower (proportionately lower) a share price.

No change in value.

Over the course of the past century, investors have somehow become increasingly conditioned to think that having more shares is better -- and, conversely, that having a higher share price is somehow worse. Nay! Two of the best-performing stocks over the past 40 years are Wal-Mart and Berkshire Hathaway. One split numerous times, the other never has. Both are HUGE. It's about companies, not stock prices.

Why?

Why do companies split their stock? Well, the conventional explanation is that they want to have lower share prices in order to attract a wider group of shareholders. The idea is that not as many people can afford to buy shares of Starbucks at $53, as can afford to buy it at $26 1/2. So SBUX management says, "Split."

OK, but is this really significant? Buying odd lots (3 shares versus, say, 100 shares) is no longer a significant penalty or a difficult thing to do. So this whole "keep-the-share-price-smaller-for-the-little-guy" idea doesn't convince me. People with very little money -- the people that would supposedly be "priced out" of a higher-priced stock -- make up an irrelevant percentage of capitalization for most public companies. Obviously, I write that from a belief that shareholding should be consumer-based, mass-market-driven, and democratized, and I do believe in time that it WILL, and that we at The Motley Fool will continue to work hard at democratizing our markets. But few people who are investing can't afford a share of Starbucks at $53. And even for companies that have share prices of $300 or $500 or higher, Fools can use services like Sharebuilder to buy fractional shares, anyway.

This is Probably Why They Do It

I find it much more likely that the phrase "stock split" has a wonderfully positive connotation -- it's a phrase with BUZZ -- and that companies want to associate their equity ownership with that buzz. We all know that most great stocks have been around a long time, and have from time to time split their stocks, so that many studies wind up showing that companies that split their stocks -- stocks that get split -- do better than ones that don't. But this is a rather misleading, backward-looking argument: It's like arguing that companies that succeed happen to use new technology, simply because the ones that aren't around anymore can't obviously use that new technology! It's a tautology. This is about correlation, not causation.


A Subtle Concluding Point on This

There IS actually one dependable and good reason why companies splitting their stocks is bullish, but it's a reason you don't see written about in the popular press. Here it is: Consider that few solid companies want their stock prices to decline below $10 a share, as this tends to cause the stock to fall off the institutional buying radar. (Many institutional buyers traditionally shun stocks trading in the single digits -- so you lose potential buyers when this happens.) Thus, any company that splits its stock is willingly putting its shares in more jeopardy, by dropping them closer to that danger level. In this way, the company is effectively saying, "Things are looking good enough to split our stock. We the management are confident enough in our business's near-term prospects to drop our shares nearer that danger level." This is the only argument, to my way of thinking, that explains why stock splits are bullish. It doesn't always work, but it does play out frequently enough to be pretty reliable.

Conclusion

Now I hesitated even including the previous section, because my overall point is that investors everywhere are way too jazzed, too fired up, about stock splits, to the point that they risk being cynically manipulated by companies with more dubious prospects that split their stocks simply to juice speculative buying. Some Internet sites and blogs are even dedicated to tracking split stocks -- let alone people who set mobile alerts to let them know which stocks are splitting and when. So when we hear investment strategies tossed out like "Oh yeah, you just buy before the split, get that bump up, and then sell," I'm convinced that's promoting spotty short-term speculative buying of a sort that will never be sustainable, and will eventually redound back upon its practitioners. So I believe this form of "investing" will ultimately burn those who focus on it.

But hey, to close on the ironic note we began with: "When do you think RuleBreakerStock.com will split?"

And, should I eat the pizza before or after it's been sliced?


adapted from: http://www.fool.com/portfolios/rulebreaker/1999/rulebreaker990224.htm

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