How a stock split affects your portfolio

Investors who think the days of stock splits are over should think again. In recent years, several companies have done one — Netflix being one of the latest with its 7:1 split in July 2015.

Steve Barban has seen this firsthand. He points to the 40-stock portfolio he manages. “In the last couple of years, four out of the 40 have split,” says the principal, senior financial advisor at Gentry Capital/Manulife Securities Inc. in Ottawa. For instance, Canadian retailer Dollarama, which he owns, split 2:1 in September 2014.

So, as companies continue to do stock splits, it’s important to understand what the mechanics mean for your investments.

Why split stock

Company fundamentals

A stock split is generally good news because it means the company thinks it has solid fundamentals.

“Only companies that have had wonderful share price run-ups [want] to split their shares,” says Barban. “It tells the market the company is doing well, and investors think, ‘If it splits, it’ll just keep going back up again.’ ”

And his research shows this is the case. “I’ve [seen] the bump up in price has been as high as 10% on average,” he says. “But there is no bump up in the long-term unless the company continues to do well.”

Barban uses the example of Dollarama. Its October 2009 IPO price was $17.50 per share. The stock increased to about $95 per share before it split last year, and after the 2:1 split it’s trading at $87* per share.

Tim Johnston, chief listings officer at Aequitas NEO Exchange in Toronto, agrees that splits suggest future gains. “What you saw in Netflix also is that there was strong aftermarket performance subsequent to the announcement of its stock split. [The company was] sending a signal to the market that it expected to continue doing well.”

Netflix’s price per share was about $700, and it dropped to at least $110 after the split since the split was 7:1. Today, it’s trading at around $103* per share.

Still, Johnston cautions investors against rushing to buy just because a company splits its stock. “If I wasn’t a buyer of the security previously, ask, ‘What’s changed?’ Investors should still evaluate the company, its growth initiatives and opportunities.”

Also look at where the company is in its business cycle, whether it’s got a competitive advantage relative to its peers and what the value of the stock is relative to its earnings or operating profits, says Andrea Horan, principal at Agilith Capital Inc. in Toronto. “Those [factors] don’t change based on the absolute share price.”

Netflix would have been on Barban’s buy list whether it had split or not. He says the media streaming company continues to attract new subscribers each month, and it also develops original content, which is key to its business model. “So even after its share split, you still want to own Netflix because it’s a smart business.”

Affordability

Another reason a company might split stock is so that it’s easier for retail investors to buy a board lot of 100 shares, which is typically the minimum requirement.

“It’s not that you can’t trade positions below that,” says Johnston, “but typically investors prefer to execute transactions on the basis of board lots.”

Why? An exchange will charge more to process trades of fewer than 100. And, you can only do options like puts and calls with board lots. With fewer than 100, “You have to take the market price,” notes Horan. “You can’t say, ‘I’ll sell it at $10 but I won’t at $9.’ ”

Determining price

If a company is contemplating splitting its stock, it’ll discuss the stock’s trading dynamics, and both institutional and retail interest, with its advisors (i.e., investment banks).

“In many cases when a stock appreciates strongly, senior management is interested to understand whether the current price level is limiting retail trade,” explains Johnston.

And, Horan notes, depending on the company, the sweet spot for trades is usually between $5 and $50.

When Apple did its 7:1 split last year, Barban says the average share price of other companies likely played a factor. “[The company’s] share price was around high $500, maybe $600 a share before it split. And seven-for-one would have brought it down to around $80 to $90 per share, which was the average of the other Dow Jones companies.”

Reverse splits

If a company’s stock price declines too much, it risks being delisted.

“TSX does not have a set minimum share price,” says Mathieu Labrèche, manager, corporate communications and public affairs at TMX Group Limited in Toronto. “However, the exchange monitors share price, as low share price is included [in the] criteria for delisting.”

Nonetheless, if share prices are low, a company might consider a reverse split, which is the opposite of a stock split. For instance, say a company has a stock valued at $1. In a 1:10 reverse split, the stock price would become $10.

However, investors should pay attention to the reason behind the reverse split. “If I were going to take any message from management, it’s that they don’t see an immediate path through fundamentals to get their share price up over $2 [or another threshold],” says Horan.

In Barban’s experience, companies that do reverse splits may be trying to avoid bankruptcy. He cites the famous example of Nortel, which in 2006 did a 1:10 reverse split from about $2 to about $20 on both the NYSE and TSX.

These days, he says it’s typically junior mining companies that end up doing reverse splits. Why? “Because they’re the ones that go into free-fall when news gets out that they haven’t found anything. When investors see they have no product and they’ve got nothing to mine, they [sell their shares].”

Still, it’s not all bad news. Most brokerages will not allow investors to use margin to buy a stock valued at less than $2, depending on the stock and exchange, explains Horan. If a company does a reverse split to get its price above that hurdle, investors can once again use margin to buy it.

“So if it gets to be a penny stock, ask yourself, ‘Are there disadvantages to owning it?’ ”

Again, Barban suggests paying attention to business fundamentals. “If a company is about to embark on a reverse split, [negative sentiment about the company is] already in the news. I would get out of [the stock].”

*All stock prices current at time of publication