Surprising Payoff from Stock Splits

06/08/2011 10:56 am EST

Focus: GLOBAL

John Heinzl

Reporter and Columnist, GlobeInvestor.com

While splits do not in and of themselves add economic value, they can be a positive sign for the future, writes John Heinzl, reporter and columnist for Globe Investor.

Why do companies split their stock? Am I really gaining anything as a shareholder when they do this?—A.V.

This is a timely question, because after a long dry spell we've recently seen several companies split their shares.

Last week, pipeline operator Enbridge (ENB) split its shares 2:1—its first split since May 2005. Others that have announced splits in recent months include Lululemon Athletica (LULU, Toronto: LLL), Potash of Saskatchewan (POT), and Magna International (MGA, Toronto: MG).

The main reason companies split their shares is to make the price more attractive for retail investors. The theory is that people are more likely to buy a board lot of 100 shares if the price is $50 instead of $100. A company may also authorize a split to increase the liquidity of its stock.

In addition, Enbridge said it "believes the split will keep the trading range of ENB shares better aligned with Enbridge peers in the energy-infrastructure business."

Do you gain anything as a shareholder from a split? The short answer: not really. You'll have twice as many shares, but they'll be worth half as much, so you'll be no better off.

While a split does not in and of itself add economic value, it can be a positive sign for the future.

In a 1996 study, David Ikenberry of Rice University studied the short- and long-term returns of 1,275 companies that split their stock two-for-one from 1975 to 1990. He then compared their performance to companies that did not split.

Result: The splitters outperformed the non-splitters by eight percentage points after one year, on average, and by 16 percentage points after three years.

In a later research paper, Ikenberry—who is now with the University of Colorado—studied companies that split their stocks 2:1, 3:1, and 4:1 from 1990 to 1997.

The results were similar: The splitters again outperformed by eight percentage points after one year, and 12 percentage points after three years.

NEXT: Profit Growth

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Profit Growth
There's also some evidence that a stock split is a predictor of earnings growth.

According to a 2003 study of Canadian stocks from 1977 to 1993, by Said Elfakhani of the American University of Beirut and Trevor Lung of San Diego-based First National Home Finance, "it appears that earnings grow in the two-year period following split events, thus implying that split events signal future performance of the firm."

When you think about it, it makes sense that companies that split do well. After all, a split is usually preceded by a sizable rise in price, which often reflects a company's strong or improving fundamentals. Assuming the company continues to perform well, the stock will rise.

It's also possible that the lower price after a split attracts more investors, who push up the value of the shares. Yet another explanation for the phenomenon is that many companies announce dividend increases and other positive news when they split their shares, and this drives up the price.

Berkshire and Buffett
Still, not every company is a fan of stock splits. Google (GOOG), for example, has never split its stock.

And Warren Buffett's Berkshire Hathaway resisted until last year, when it split its class B shares (BRK-B) 50:1 to facilitate the purchase of the railroad operator Burlington Northern Santa Fe Corp.

Berkshire's class-A shares (BRK-A), however, have never split, and trade at a vertiginous $112,120. [Incidentally, the B-share split reduced its price to a remarkably-reasonable-for-Berkshire $69.50, from nearly $3,500 beforehand—Editor.]

Buffett has said he preferred not to split Berkshire's stock because it helped him attract "the best shareholders"—people who don't watch the stock price from day to day, but are investing for the long haul.

Reverse Splits Can Have a Reverse Effect
The opposite of a split is a stock consolidation, also known as a reverse split. For example, in a 1:10 consolidation, an investor who owns 1,000 shares worth $1 each would end up with 100 shares worth $10 each.

Reverse splits are sometimes initiated to raise a company's share price if it is in danger of being delisted by a stock exchange, or to make the stock more attractive to investors who may be reluctant to invest in very low-priced shares.

Reverse splits are often associated with companies in financial trouble. One example is US insurer American International Group (AIG), which in 2009 did a 1-for-20 reverse stock split.

[An even bigger, more recent example was the Citigroup (C) 10:1 reverse split last month. Since then, the stock has fallen another 15%. That’s still better than AIG, which fell more than 40% in a week after its consolidation—Editor.] 

There are many factors to consider when buying a stock. But if a company has a history of splitting its shares—particularly in combination with a rising long-term trend in profits and dividends—it can often be a positive sign.

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