Tuesday, November 5, 2013

Some Real Thoughts On Stock Splits

Another post inspired by a WSJ CFO Journal article. (The article is found here. My prior article inspired by WSJ was on non-GAAP measures, which is here). The WSJ article discuss how corporations should consider revisiting stock splits. The author claims that academic studies have shown that the companies who split their stock will outperform the market. It is clearly the author supports the idea that a stock split will create value for its shareholders. However, my own opinion on share splits is quite the opposite: It's distracting tactic that management use to boost the stock price in the short term and does not create any value at all. Why would management want to boost short term share performance? The answer is simple: stock options grants (I'll save the topic of executive compensation for another day).

For those who are not familiar with the concept, a stock-split is a transaction that increases the company's shares outstanding by a specific multiple (usually 2 times or 3 times) and reduces the trading price of the stock by the same multiple. Here is an example to illustrate a stock-split: stock X is trading at $100 and has 1 million shares outstanding.  If it announces a 2:1 stock-split, the number of shares outstanding  doubles to 2 million and the stock's trading price would halved to $50. The company's market capitalization remains at $100 million (market capitalization is the market value of equity calculated by multiplying shares outstanding by the share price). No matter how you slice and dice it - i.e. $50 x 2 million, $33.33 x 3 million, $20 x 5 million -, the market capitalization is still $100 million. The famous Yogi Bear once said to the waiter after he ordered a pie: "Please cut it in 4 pieces instead of 8 because I can't eat 8 pieces". It doesn't matter how the pie is cut, Yogi Bear will still eat one whole pie. The fact he thinks he is eating less because he ate less pieces is plain silly.

This quote from the article made me laugh: "Kenneth Fisher, Noble Energy’s CFO, says the company’s research indicates companies that split outperform their peers by 2% to 3% in the near term.". The emphasis in that quote should be on the last two words in his sentence: NEAR TERM. 

If stock splits do create value, then companies with the high trading prices should be less attractive to investors. History suggest otherwise. Lets take the three highest priced stocks in the S&P500 which had no stock split in the last 10-years and look at their performance. The three companies with the highest trading prices are Berkshire Hathaway (at $171,700), Priceline.com (at $1080), and Google (at $1020). In the past 10 years (November 2003-present), the S&P500 only returned 60%. What about those stocks with the highest trading prices? Berkshire returned 120%, Priceline returned 5000% and Google returned 800% in the same period. Granted, although Priceline and Google were trading at prices below $100 in 2003, their executives never considered a stock split when their shares soared above $100 like most other S&P500 chiefs. Thus, the evidence suggests that high trading prices do not hurt share performance at all. So why do most CEOs want a stock split? 

Most S&P500 CEOs usually do a  2:1 or 3:1 split when the price of the company's shares soar above $100 because they believe they can create value by lowering the share's trading price. By lowering the trading price, CEOs think they can psychologically impact investors' perception of value just because the price per share is lower or liquidity in the stock has increased. While I agree most companies may experience short-term outperformance after a share split, the long term costs of the share split is negative for shareholders. Stock splits increase administrative and market listing costs because the shares traded more often (more turnover). Also, stock-splits generally attract more short-term oriented investors and increase management's incentive to try to meet quarterly earnings forecasts as the shareholder base becomes increasingly short-term oriented. There is nothing more value destroying in the long run than management trying to play the earnings beat game. Management may try various schemes to meet short term earnings expectations such as cutting expenses (instead of growing revenue), focusing on short term payback projects (instead of projects with the highest NPV), or doing ridiculously high priced acquisitions (which maximize short term earnings accretion but hurt long term value because they often overpay or issue undervalued stock to finance such acquisitions).

Therefore, stock-splits add zero value and it's just a short term tactic aimed at boosting investor's short term enthusiasm. If you hear a CEO talk about the benefits of a stock split, ask him/her whether 1 x 10 =  2  x 5  If he/she says yes, then you should reply why consider a stock split in the first place when the left hand side of the prior equation is equal to the right hand side. Actually the equation should be 2 x 5 - costs < 1 x 10  because stock splits will increase costs. Long term shareholder value can only be created if management focuses on building the underlying business (invest in positive NPV projects, return excessive free cash flow, and allocate capital efficiently) and generate a high return on capital. As Buffett famously said: "If the business does well, the stock will follow". If a CEO thinks his/her company should consider a stock split because the trading price is too high, he/she is spending way too much time looking at the company's stock price and not enough time building the underlying business. 

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