Talk to an investor with more than 20 years of experience and you may hear tales of the good old days when Wal-Mart regularly split its stock like clockwork. Today, however, companies rarely announce stock splits, and one day soon they may be as rare as hen's teeth. So what is a split, and why are they going the way of the buggy whip?
Stock prices quoted in the paper or on the internet convey the current market value of one share, the smallest unit of ownership in a public company. For example, suppose that Wal-Mart is trading at $70 per share, and you wish to buy 100 shares. The total value of your purchase (ignoring trading costs) is $7,000.
Christopher HopkinsWhen a company announces a stock split, the economic value of the investment remains constant but the number of shares and the price are adjusted accordingly. So, if Wal-Mart splits 2 for 1, you will find yourself holding 200 shares, each of which is now worth $35. Note that you still own $7,000 in total, but now have twice as many shares each of which is worth half as much.
Companies formerly split their stock in an effort to keep their shares affordable to a broad spectrum of individual investors. In a bygone era of traditional brokerage commissions, investing in equities could be quite expensive for smaller customers. Prior to the deregulation of stockbroker sales charges in 1975, a typical trade could cost hundreds of dollars. Minimum commissions were based upon a quantity of 100 shares, known as a "round lot." So it was usually too costly to purchase less than 100 shares. If the price climbed too high, the stock became unaffordable for smaller investors.
To address the problem and expand the universe of investors able to buy a round lot, companies would announce an increase in the number of outstanding shares and a proportionate reduction in the price per share. Often, the ratio was 2 for 1, but could be any multiple (say, 3 for 1 or 3 for 2). The total value of existing positions remained constant, but each share became cheaper for new investors to buy.
Because the number of potential customers actually increased, stock splits did usually trigger a bump in the price. Investors soon recognized the pattern, and began timing their purchases immediately following a split to capture short-term profits from this transient price spike.
Today, deregulation and the advent of electronic discount brokerages have rendered trading commissions practically immaterial, so the concept of "round lots" has lost significance. Investors may easily purchase five shares of a $1,000 stock for a commission of $7 or less. As a result, fewer companies are bothering with the expense and hassle of splitting their shares, and investors understand more clearly that a stock split has zero economic value. And the explosion in institutional ownership has reduced the concentration of individual buyers to less than 30 percent of all shares.
Occasionally, a firm may utilize a "reverse split" to reduce the number of shares and boost the per-share price. This is usually done when a stock's price dips below $5 per share, the minimum value for listing on the stock exchanges. Citigroup engaged in a 1-for-10 reverse split in 2011, boosting the share price from $4.50 to $45 but leaving the total market capitalization unchanged. These are special cases and may signal financial distress.
But for traditional splits, given the changes in trading costs and institutional ownership, most investors understand that stock splits change nothing fundamentally and will continue to fade away.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.