You hear it time and time again.
“Stock splits are meaningless.”
Many very influential and successful investors have said it. Even Warren Buffett, maybe the most influential and successful investor of all, refused to split Berkshire Hathaway stock for over 30 years.
But there are meaningful benefits to splitting stock. In this article I want to point out a few of them and dispel this not-quite-true notion.
What Is A Stock Split?
A company’s market capitalization – that is, how much the entire company is worth – is simply the share price times the number of shares a company has outstanding.
The classic “pie” metaphor explains it perfectly. The entire company is the entire pie. Each share is a slice of the pie. Most public companies have a lot of slices – usually tens of millions, and it can even get into the billions for larger companies!
A stock split is simply when the company takes each slice of the pie and cuts them into even smaller pieces. So where the pie may have previously had 10 million slices, now it has 20 million. The important thing is that THE PIE IS STILL THE SAME SIZE! It just has more pieces.
Take Apple (AAPL), for instance. Say you owned one share at $700 when the company split its stock 7-for-1 in June of 2014. You now had 7 shares, but the price of each was $700. Same $700, just 7 shares instead of 1.
Benefits of a Stock Split
You can see why many market commentators pooh-pooh stock splits. By the numbers, it has no effect on your economic stake in the company.
But there are other reasons why a split is beneficial. Here are 4 practical ones for individual investors:
Expands the shareholder base. Many small or beginning investors start by investing in small amounts. If they have only $1,000 to invest, their entire investment would nearly be eaten up by one share of Alphabet (GOOG). They couldn’t even buy a share of Priceline (PCLN)! Additionally, although illogical, it can be a very difficult psychological barrier for a new investor to spend large per-share amounts on a stock. By keeping share prices at reasonable levels, companies encourage investment by even the smallest market entrants.
Makes portfolio management easier. It is a pretty common activity in portfolio management to rebalance positions or to sell a portion of one investment to fund a new one. High per-share prices make this more difficult, as you are dealing with larger chunks of your portfolio with each share.
Makes put selling options possible. A popular and relatively safe options strategy involves selling puts to enter a position. The problem is that most brokers require you to have the full amount in cash to purchase shares if you get put. Each options contract represents 100 shares, so if you wanted to sell a put on Priceline (a $1,300/share stock), you would need a cool $130,000 in cash on hand! On the other hand, if Priceline were to do a 100-for-1 split to $13/share, you would only need $1,300 for each contract – a much more realistic scenario.
They typically outperform the market over the next several years. In a study performed by David Ikenberry of Rice University, he found that stock splits substantially outperformed the market over both 1 and 3 year periods from the date of the split. What better beneficial reason could an investor want?
