Corporate management at times makes the mistake of excessively splitting its company’s stock. This is sometimes done based upon questionable advice from the company’s Wall Street investment bankers. It is usually better for a company to split its shares 2-for-1 or 3-for-2, rather than 3-for-1 or 5-for-1. Another thing that may happen is that the stock is split very often.
What is a stock split and how does it work? When a company splits its stock, say 2-for-1, you get two shares for each one previously held, but the new shares sell for half the price. You do own twice as much stock, but at half the price the value of your holdings does not change after the split. However, for every $1 the stock advances, you make twice as much as you did before the split and vice versa for every $1 decline.
Now back to the point about excessive stock splitting. Overabundant or numerous stock splits create a substantially larger supply of stock on the market and may put a company in the more lethargic performance status sooner. This is because of the huge amount of outstanding shares that exist in the market.
In addition, it just happens that companies whose stocks’ have gone up in price for a year or two, often have extravagant stock splits near the end of a bull (up) market or during the beginning of a bear (down) market. Corporate executives think the numerous stock splits will attract more buyers if its stock sells for a cheaper price per share. This may occur, but most often has the opposite result the company wants, particularly if it’s the second split within a couple of years. Knowledgeable professionals and a few shrewd traders will probably use the oversized split as an opportunity to sell into the “good news” and excitement and take their profits.
According to Investor’s Business Daily (IBD) writer Vincent Mao, “Too many stock splits create a flood of supply, which can weigh on share prices. This is especially key if those underlying stocks have had long, sharp advances near the tail end of a bull market or early in a bear market.” And IBD’s founder William O’Niel writes, “A stock will often reach a price top around the second or third time it splits.”
Large institutional holders who are thinking of selling might feel it easier to sell some of their 100,000 shares before the split takes effect than to have to sell 300,000 shares after a 3-for-1 split. And smart short sellers (people who take advantage of a down stock or market) pick on stocks that are beginning to falter after enormous prices run ups—three-, five- and 10-fold increases—which are heavily owned by mutual funds. The funds could, after an unreasonable stock split, find the number of their shares tripled, thereby dramatically increasing the potential number of shares for sale.
Finally, this article is mostly concerned with the negative aspects of excessive stock splits. However, stock splits can be good for a company’s stock as long as they are reasonable and do not put an excessive amount of shares on the market.
Quote of the Week: “Right now, cash is my favorite market.” — Barton Biggs (then of Morgan Stanley on April 7, 1998—just as the DotCom Bubble was forming)
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.