Are stock splits good for investors?

The answer may depend on how long you hold the shares

Published: June 29, 2015 02:00 PM

Stock splits are back. Netflix is the latest Standard & Poor’s 500 company to announce that it’s splitting its shares. Owners of 100 shares of Netflix, worth roughly $700 each in June, will soon own 700 of them at one-seventh the price. Netflix's split announcement resembles that of Apple, which also split its shares 7 for 1 in 2014.

Mere cosmetics, you say? Many in the financial media seem to think so. Even Jim Cramer doesn't seem to think the split matters much. So why do companies bother?

Engaging users

Stock splits, at least in part, may be moves companies make to continue engaging the interest of individual investors, and that may be even more true when it comes to big household names like Netflix and Apple. By splitting their shares, these companies appear more accessible to individual investors, even though the fundamentals of the company don't change. In addition, the companies are signaling to investors the future prospects of the company remain positive. Indeed, many stock splits are announced simultaneously with dividend initiation or increases, the other positive signal corporations offer investors.

Not all companies split shares in exchange for a fleeting spotlight and possible near-term gains. The most obvious example is Berkshire Hathaway, a company that has never split its stock in its 50 years. In his biography "The Snowball", Warren Buffett suggests that splitting Berkshire's stock would be a losing proposition for all concerned—disappointed traders looking for a quick buck, and Buffett having to respond to these short-term owners. Nonetheless, even Berkshire Hathaway offers a more friendly version for smaller investors: the Berkshire "B" shares trade at 1/1500th the price of the traditional A shares, the latter of which are currently valued at over $200,000 per share. (Initially 30 B shares were equivalent to one A share, but the B shares were split by Berkshire 15 years after their 1994 launch.)

Read about a new exchange-traded fund that focuses on stocks that are buying back their own shares.

But despite the emotional appeal of a "smaller" price, stock splits are becoming somewhat of an artifact. A half-century ago, corporations split their stock in order for investors to trade them in lots rounded to the nearest hundred; otherwise, the commission would increase for buying and selling "odd-lots." Today, investors don't need to worry about additional fees for odd-lot trading: None of the major online brokerages charge additional commissions or fees for trading, say, 26 shares of Netflix instead of 100

In addition, individual investors are no longer the market they once were. If you look back 40 years, individuals still traded more stocks on an average trading day than institutional shareholders. But today, trading by hedge funds, pensions, and mutual funds dwarf that of trades done by individuals. 

Short-term benefits

Are stock splits even good news for shareholders, no matter who the owners are? According to research, the results appear mixed. One study, focusing on stock splits from the 1920s through 1950s, found that they didn't matter; after 30 months, split stocks did no better than others. But research focusing on more recent history found that stocks that split outperformed the market by about 8 percentage points in the year following the split.

And since there is seemingly an exchange-traded fund for every market phenomenon, it may come as little surprise that there's an ETF that owns shares of companies that have recently split shares. The Stock Split Index fund (ticker: TOFR), launched last September, invests in 30 recently split stocks.  Since its September 2014 inception, the ETF has returned 9.7 percent, more than the 3.9 percent of the broader market, as measured by the Vanguard Total Stock Market ETF. But be aware that, according to Morningstar data, it currently only manages some $5 million in assets. ETFs this size are often liquidated, with cash (and sometimes capital gains headaches) returned to shareholders.

Reverse stock splits

Finally, there's one type of stock split that almost always is bad news for investors. Those are companies that engineer reverse stock splits, by combining existing shares into one new share. For example, a 1-to-10 reverse stock split would trade 40 old shares priced at $2 per share into 4 shares priced at $20.  

Often, the reason companies do this is to meet the listing requirements of major stock exchanges like the New York Stock Exchange and Nasdaq, both of which require stocks listed on their respective exchanges to have a minimum value of $1 per share. Generally, the prognoses of companies that undertake reverse splits are poor. A recent study confirms a suspicion that reverse-split stocks will continue to lose value.

–Chris Horymski

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