Stock splits make markets go bump

Advisors who think that 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 activity firsthand. The principal and senior financial advisor at Gentry Capital, Manulife Securities Inc. in Ottawa points to the 40-stock portfolio he manages for examples.

“In the last couple of years, four out of the 40 have split,” he says. Canadian retailer Dollarama, for instance, split 2:1 in September 2014.

So, as companies continue to do stock splits (see “How a split works”), it’s important to understand what the mechanics mean for client holdings.

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 […] 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.”

In the case 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. Now, after the 2:1 split, it’s trading at $90* 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 US$700, and it dropped to at least US$110 after the split, which was 7:1. Today, it’s trading at around US$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 is so that it’s easier for retail investors to buy a board lot of 100 shares, which is typically the minimum trading requirement.

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

Why? An exchange will charge more to process trades of fewer than 100. Also, you can only do options like puts and calls with board lots. With fewer than 100 shares, “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.’ ”

Why companies refuse to split stock

Some examples of companies that have never done a stock split include Berkshire Hathaway† and Priceline Group†.

“They may want to keep it at this high number because it avoids speculators in the stock and only attracts investors,” says Steve Barban, principal, senior financial advisor at Gentry Capital, Manulife Securities Inc. “So you’re not going to have someone getting in and out.”

Andrea Horan, principal at Agilith Capital Inc., adds it could also be about cachet. “It’s [saying,] ‘Look at how much value we’ve built.’ If you go back down to $50, you’re back in with the crowd.” But she notes, in her experience, most successful companies eventually have to reduce their share prices to continue attracting retail investors.

Broker fees

Historically, brokers would charge based on how many shares an investor bought, so it was cheaper to buy before a split happened. Now that brokers charge flat trading fees, this is no longer an issue. However, most brokers have sliding scales for trade commissions, with a break usually below $5, explains Horan.

“If a stock goes from $6 to $4, for instance, it could be cheaper to trade.”

How a split works

Once a company decides to split its stock, the share price decreases and the number of shares increases.

Say a company’s stock is valued at $1,000 per share, and it decides to do a 10:1 split. Each stock will then be valued at $100 instead ($1,000/10). This makes it more affordable for investors to buy.

Meanwhile, the split doesn’t change the underlying value for shareholders. They’d just get 10x more shares. So if a shareholder owned 100 shares valued at $100,000 prior to the split, he still owns $100,000 worth of stock after the split. But now, he has 1000 shares (100 x 10). And, even though the number of shares increases after a split, liquidity remains the same since the value of those shares remains the same.

Determining price

If a company is contemplating splitting its stock, it’ll first 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 [the] high $500s, 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.

“The 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. Say a company has a stock valued at $1. In a 1:10 reverse split, the stock price would become $10.

Shareholders should still pay attention to the reason behind the reverse split. It may be an indicator that management doesn’t “see an immediate path through fundamentals to get their share price up,” says Horan.

And companies that do reverse splits may be trying to avoid bankruptcy. Barban cites the famous example of Nortel, which in 2006 did a 1:10 reverse split from about $2 to about $20 on the NYSE and TSX. These days, he says, it’s typically junior mining companies that do reverse splits. Why? “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 says pay 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].”