When the price of a stock goes up to a sizable dollar value say $100 or more, individual investors are more reluctant to buy. Or at least that’s what corporations and their investment bankers seem to think. And to a certain extent it makes sense: Smaller investors with, say, $5,000 and a desire to buy shares in round lots (increments of 100 shares), can handle 100 shares of a $45 stock, rather than 100 shares at $110. Therefore, companies often split the price of their stock in two (or other multiples) and deliver over to existing shareholders twice the amount of stock.
In essence stock spits are in many ways similar to stock dividends, but there are certain important differences. When a stockholder receives more than 25 percent additional shares, it is usually called a stock split. This is a rule of thumb used by the New York Stock Exchange. In this case, the number of shares is simply increased, usually by reducing the value the stock.
In nearly all cases companies split their stocks only after they have moved significantly higher. It stands to reason, then, that if a stock has undergone several splits within a relatively short period, say 18 months, it has moved rapidly higher and may have reached the end of its run.
The same idea can be applied to the market as whole. A large number of stock splits in the market indicate that the entire market may be nearing a high. Many market information services list the total number of stock splits over a short period of time.
On the other hand, a low number of splits reflects a market that has gone nowhere for while, and which may be ready to turn to the upside. That was the case in November of 1990, just after that year’s bear market had hit bottom. Splitting also was lower in November of 1994 before a major move to the upside.
While many people get excited about stock splits, too many splits in a market is often the sign that the market is overheated and over-valued and vice versa when there are very few splits.
According to William O’Neil, founder of the daily financial newspaper Investors Business Daily, “In my opinion 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. Overabundant stock splits create a substantially larger supply and my put a company in the more lethargic performance, or ‘big cap,’ status sooner.”
O’Neil goes on, “It is particularly foolish for a company whose stock has gone up in price for a year or two to have an extravagant stock split near the end of a bull (up) market or in the early stage of a bear (down) market. Yet this is exactly what most corporations do.”
As always, do your homework before you buy any stock. And for Pete’s sake, don’t buy a stock just because management announces that it is gong to split its stock.
Quote of the Week: “A loss never bothers me after I take. I forget it overnight. But being wrong — not taking the loss that is what does damage to the pocketbook and to the soul.” — Jessie Livermore
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.