Split Decisions
from Autumn 1998
by Robert A. Bennett
The headline screamed: “How to Double Your Money Every Month with Stock Split Strategies.”
Take note, directors.
The headline appeared with scores of similar ones in a free newsprint catalog published by the Learning Annex that circulates widely around New York City. The May 1998 catalog, in which the ad appears, also touts education in such subjects as “Enhancing Sexuality” and “Psychic Development.”
As a school, the Learning Annex is a bit unusual. Just about anyone can offer a course, and the “teachers” get paid on the basis of the number of students they attract.
“Oh, my god, I get so many students,” says Lea Lerman, who teaches the stock split course. “I get 80, 90 students for each session; my class is the most popular.”
Indeed, evidence abounds proving how attractive stock splits are with America’s small investors. Several Internet sites are devoted to stock splits, and there are at least two fee-based services that email announcements of stock splits directly to subscribers.
As all directors know, such wild enthusiasm doesn’t seem to make much sense—not on the surface, at least. Despite abundant studies, why a stock’s price goes up after a split is announced remains a mystery.
There’s no obvious reason for the gain. Following a split, an investor has nothing of greater value, except the number of shares he or she holds. If Mary held one share of stock worth $100 before the split, she would hold two shares worth $50 each following a 2-for-1 split. Why then, do some investors, primarily small ones, get so excited about such simple mathematics?
Who knows? But the enthusiasm itself is what leads many companies down this primrose path. More pragmatically, do stock splits really help the company and boost the ongoing price of its stock, or do they merely roil the investment market, creating “sound and fury, signifying nothing?”
This is the tough question facing directors. “Much research has been done about the impact of stock splits, most of which is inconclusive,” Nasdaq reported in a 1992 study of the phenomenon.
Many, if not most, companies that regularly split their stocks do little analysis to determine scientifically whether the split has had the desired consequences. “There’s not a lot of science about it,” says L. Nash Allen, Jr., chief financial officer at BancorpSouth in Tupelo, Mississippi, which split its stock earlier this year. “It’s a gut feeling.”
Splitting the stock can become a habit. “We’ve had a pattern over the years of splitting our stock when it got in the mid-40s, and we just continued that. We like the stock trading in the $20–$40 range. The price is a lot more affordable for people to buy,” Allen explains.
But in real terms, stock splits aren’t as important as they once were, even to small investors. Before electronic accounts were introduced, individuals had to pay extra-high brokerage fees if they wanted to trade in odd lots, or transactions of less than 100 shares. Thus, the penalty for odd-lot trading was stiff. As a result, splitting a stock made it more affordable for individual investors, broadening market demand.
Today there is no direct penalty. Most brokerage firms charge fees based on the dollar amount of a transaction—the number of shares means little. So, if a company’s stock is selling at $20, an investor needn’t put up $2,000 to buy 100 shares. He could buy 50 shares and still pay the same fee.
And from the point of view of market power, individual shareholders have become substantially less important than institutional holders; as a result, their decisions have less impact on a stock’s price. Much of today’s stock-split-based trading appears to be an emotional throwback to what had been.
Yet, that “gut feeling” that Allen talks of appears to be valid. Some 821 companies split their stocks last year, according to Standard & Poor’s, which is predicting another record-breaker for 1998. And evidence is mounting that the strategy works: S&P reports that split shares typically outperform the market in the 18 months following the split. It’s a sure bet that the directors of Atlanta-based Mindspring Enterprises, Inc. believe in splits. On June 24, the Internet access provider announced a 3-for-1 stock split in order to meet the demand from small investors to own a piece of its burgeoning business. The day after the split, the stock rose more than 17%. The Mindspring stock hit an all-time high of $96 before closing at $94.25 on Nasdaq, where it was among the most active issues. Before the split, the stock had never risen above $85.25.
A split may provide an array of advantages. Following a split, for instance, a stock becomes more liquid and less volatile as the number of shares expands. And this, proponents say, makes a stock even more attractive for holders. Perhaps most important, a split indicates to the world that management expects the company to continue doing well. “It shows we’re confident of prospects for our company,” explains Scott Vanderheide, director of investor relations at Houston-based El Paso Natural Gas, which announced a 2-for-1 stock split in January.
Often, the impact of stock splitting depends on who holds the shares. Institutional shareholders tend not to like splits because they make trading more costly. Most institutional investors pay brokerage fees on the number of shares traded, not on the absolute dollar amount. Thus, the cost of trading becomes more expensive if more shares must be traded for an equivalent dollar value.
Stock splits appear to be especially helpful to companies that are owned largely by individuals, and the benefits to the company can go well beyond the stock price.
“We live in a part of the country where a lot of individuals still hold our stock,” says BancorpSouth’s Allen. “A lot of people who hold our stock do business with the company, and it’s a lot easier for them to buy the stock (after a split] than if we let it run up into the 60s or 70s.”
Although this kind of stock split doesn’t necessarily make the investor/customer richer, it usually makes them happier. First, it signals to them that their company is doing well. Second, it indicates to many—subconsciously, at least—that the company has given them a present by doubling or tripling the number of shares they own. This may have contributed to the wild buying spree noted at Mindspring earlier this year. Whatever the actual impact on the value of the shares, the split strengthens the company’s bond with its shareholders, customers, and community—elements that are hard to weigh with neat mathematical equations.
Counterpoint
But not everyone agrees that stock splits are so great. Among the naysayers is Georgeson & Co., the proxy firm that advises boards on such matters. Based on a study of 245 stock splits between January and June 1997, Georgeson’s analysts say that splits did not contribute to a reduction in volatility or to an increase in liquidity. In fact, the firm contends the opposite is true: that the short-term implications of splits were increased volatility and reduced liquidity.
Despite contra evidence from S&P, SNL Securities, and others, Georgeson officials say their survey of the effects of stock splits from 1962 to 1985 showed “a 4.4% cumulative abnormal return” in the three days following a split announcement, a difference that totally evaporated within 60 days. “Why would an intelligent investor be willing to pay more for the same amount of prospective earnings just because they are divided into smaller pieces?” asks Richard Wines, a managing director at Georgeson.
Clearly, some do. Waves of investors begin speculating in a stock once they expect it to split, which causes trading volume—and volatility—to soar. El Paso Natural Gas, for example, announced a 2-for-1 split on January 21, 1998 that became effective April 1. Before the announcement, its average volume was about 100,000 shares a day. Volume kept growing after the announcement, and on April 1, when the split became effective, the company had more than 900,000 shares traded, according to El Paso’s Vanderheide. Recently, he adds, “volume has dropped to pre-split levels, about 200,000 shares a day adjusted for the split.”
El Paso’s price jumped around a lot, too. On January 20, one day before the announcement, it closed at $67-7/16. The next day it actually dropped, to $66-15/16. But after that it climbed sharply, to $71-3/16 on April 1, the day the split took effect. And on April 2, it climbed even higher, to $37, equivalent to $74 before the split. By April 20, the stock was selling at $38-7/16, or a pre-split price of about $77.65. That was almost a 15% gain within the month. Over the same period, the S&P 500 rose about 1%.
Similarly, Lucent Technologies hit a home run with the 2-for-1 split it announced on February 18 this year. Before the split, the stock was selling at $46-9/32 (adjusted for the split). On the day of the announcement it jumped to $49 and kept soaring. By April 3, it was trading at $72-7/8, a whopping 57% increase.
The sharp price increases experienced by El Paso and Lucent after their stock split obviously reflected the market’s strong enthusiasm for the companies’ futures. It’s difficult, if not impossible, to conclude how much of the difference can be attributed to the split alone or what might have happened to these stocks if they had not split. Timing can be critical in raising a stock’s price. And like ocean surfing, directors must catch the wave at just the right moment.
Another dramatic story is that of Lernout & Hauspie, a producer of speech recognition and translating software. The company declared a 2-for-1 split on April 1, at a time when the stock had been rising speedily for about 16 months. In early 1997, its stock was trading at $14. By April 7 of this year, it was trading at $95. Audrey Pobre, director of corporate communications for the 10-year-old company, says increased liquidity was the driving force behind the strategy. “We didn’t have that many shares outstanding, only about 17 million,” she explains. “This will help increase the liquidity of the shares.” By April 28, the split stock was trading at $63-1/8, equivalent to a pre-split price of $126.25.
Conventional wisdom holds that the stock price rises after the split, although the effect is generally less dramatic than Lernout & Hauspie’s. Edward Nebb, a partner at Morgen-Walke, the New York-based investor relations firm, says a split makes sense when a company’s performance is good and the split is relatively small. “If the stock split is modest enough, say a 3-for-2, or a 5-for-4, sometimes the stock almost immediately recovers the effect of the split,” he says.
Nebb agrees with many analysts that a post-split stock’s rise reflects the market’s optimism about the company’s outlook. Splits “may send a signal that has more an emotional impact than it does a real fiscal impact,” he says.
Conversely, speculators in stock splits pay little attention to a company’s fundamentals; they deal on how they expect the stock to behave once a split is announced. They try to anticipate stock splits and buy before they are announced. Among these speculators is Pete Barry, who gives courses over the Internet on how to profit through stock splits. He also points his clients to specific brokers.
Barry, whose says his title is “Boss,” has three elements to his formula. First, he looks for stocks that are approaching the level at which the company usually splits, often at $100. Next, as a chartist, he determines by looking at past price patterns whether the market will resist a rise to the hoped-for level. If he thinks it will, he doesn’t buy. If he feels confident that the market won’t put up resistance to that point, he’ll buy. Usually, he sells quickly after. Such investors tend to be short-term owners, and their activities create greater volatility, at least for a brief time.
Price volatility is heightened even further when option trading is involved. In part, that’s because the options writer has to cover itself against its obligation to buy or sell a stock in the near future. To leverage their money, many speculators buy call options, which guarantee they can buy the stock at a set price in the future. This generates more volume and more price volatility, because the party at the other end of the deal, the Options Clearing Corporation, often must cover its open position by buying the company’s stock. That move tends to drive up the stock’s price shortly after the announcement. Meanwhile, if the price goes down during the existence of the option, the broker sells the stock, driving the price down.
But what’s to lose? Whether or not a stock split works the way a company intends, there seems to be little downside risk. Or is there? John Morris, a Citicorp spokesman, notes that stock splits irritate some institutional investors whose costs go up. Nebb of Morgen-Walke says some analysts become annoyed because splits force them to readjust their models. Furthermore, splits produce substantial legal, mailing, and processing costs.
Remember, too, there’s cachet to a high-priced stock. Berkshire Hathaway, Warren Buffett’s investment vehicle, rules supreme in terms of stock price; it was close to $70,000 a share at last look. While not at Berkshire Hathaway’s echelon, West Coast banking giant Wells Fargo sells for around $335 a share and its price/earnings ratio is one of the highest in the banking industry. Wells split its stock only twice in its history. The first was in 1972 and the second was in 1987. “We don’t see a strong argument for splitting at this time,” says Kim Kellogg, a Wells spokesperson. “We’re largely institutionally held, but everyone knows there’s a possibility we’ll do it.” So it seems that a high-priced stock doesn’t necessarily hurt; in fact, a high price may give a stock an aura of supremacy.
With the current bull market, speculators on stock splits are riding high. But then again, it’s hard to lose in an upward spiraling market.
Time will tell whether the enthusiasm thus generated has been overdone. Much of the excitement has been spawned by traders who have had little experience in the investment business. Take Barry, who teaches the Internet stock split course. The 50-year-old spent 20 years as a marketing guru before he was laid off six years ago and started trading stocks. “I didn’t even know the market crashed back in ’87. I wasn’t really interested…”
Barry won’t say how many subscribers he has to his service, but it is possible he earns more touting his theories (a true salesman) than he does following his investment philosophy. The same may be true for Lea Lerman of the Learning Annex. Her course is actually a 150-minute lecture for which each student pays $39. With 90 students, that means Lerman grosses $3,510 for a couple of hours of work. Better returns, perhaps, than speculating in the stock market.
