Last Updated on December 10, 2020 by Oddmund Groette
Stock splits are touted as good by the mainstream investment community. Nevertheless, Warren Buffet has said that stock splits are meaningless and refused to split the stock of Berkshire Hathaway. We believe Mr. Buffett is right, despite the academic research which shows stock-splitting stocks outperform their reference groups. We believe stock splits are complicated to assess, and we need to separate the short-term and long-term effects of a stock split.
Stock splits are supposed to be financial cosmetics, but in the real world, stock splits matter. In the short-term, it seems to improve the share price, but we believe it backfires in the long-term. Stock splits attract short-term shareholders. It would help if you judged a business over a time frame of at least ten years.
The long-term value of having shareholders who act like business owners are much more valuable than pleasing short-term investors for temporary gains from stock splits. Furthermore, we believe the research is somewhat incorrect: A company splits its share price because it performs well. It’s meaningless to compare “random” reference groups. Companies that split their stocks would perform well anyway.
Let’s look at different aspects of stock splits:
Types of stock splits
There are two types of stock splits – a split and a reverse stock split.
What is a stock split?
A stock split is simply an increase in the number of outstanding shares.
Let’s assume a stock has 1 million shares issued and trades at 100. If the board decides to split the stock in half, the outstanding shares increase to 2 million, and the share price is adjusted to 50. If you owned 100 shares valued at 100, you now own 200 shares valued at 50. Absolutely nothing has changed in terms of valuation.
What is a reverse stock split?
The opposite of a split is a reverse stock split. If you own 10 000 shares valued at 2 USD, the board might decide to do a reverse split where one new share was 10 old shares. After the reverse split, you own 1 000 shares valued at 20. Your total worth is still the same.
Do you lose money when a stock splits?
No, your ownership doesn’t change, nor the value of your holdings, as seen from the above calculations. It’s only an accounting feature. Let’s call it financial cosmetics. Of course, a stock can fluctuate widely because of whatever reasons from an announcement until the split is done.
If two people split a pizza, does it matter if it’s divided into four or eight parts? Of course not, except perhaps for practical reasons on how to eat the pizza. The size of the pizza is still the same.
Why would a company do a reverse split?
Many exchanges have a minimum limit on the share price. Thus, a reason for a reverse stock split is to satisfy the exchange’s minimum share price. Most companies that do a reverse stock split has seen their stock price decrease dramatically.
A reverse stock split usually reduces the number of shareholders. Often investors holding fewer than 100 shares receive a cash payment. If the number of shareholders drops below a certain threshold, it might be governed by different law and regulations.
Why would you split a stock?
Normally a stock is split when it has risen in value. A stock trading, for example, above 500 USD limits many shareholders to purchase more shares. However, this argument should be less valid today because of the opportunity of purchasing fractional shares, which is less than one full share.
It’s normally short-term investors who want a stock split. Even though a split is purely cosmetic, many studies show a short-term boost in the share price after a split:
Do stocks go up after a split?
Research indicates stocks go up in the short-term after a split:
For example, a 1996 study by David Ikenberry looked at all splits on US exchanges between 1975 and 1990 by comparing them to a control group of similar-sized companies with no splits. Stocks that split performed 8% better in one year and 16% better after three years.
Mr. Ikenberry later confirmed his findings in a study from 1990 to 1997.
Oliver Rui, Steven Wang, and Tak Yan Leung, confirmed Ikenberry’s study on the Hong Kong market in 2005.
However, we believe the studies are missing a crucial point. The exact reason those companies perform a stock split is that their share prices have risen. And why does the share price go up? Because they produce wealth and return on their invested capital. The group of stock splitting stocks is most likely better companies than the reference groups, for example, having a higher return on capital employed in the business. Thus, this is like comparing apples to oranges.
Good companies are more likely to split than bad companies. The compounding effect makes the split group perform better as time goes by.
Why does the share price go up after a split?
Many smaller investors find it more valuable to own 1 000 shares of stock than, for example, 100 shares. Thus increased demand and the number of shareholders rises. Besides, a split is almost always done on the same day as another announcement, like for example an earnings report. If that report is positive, a split adds fuel to the fire, and perhaps even short sellers need to run for cover (and thus buy shares to close their position).
One other argument exists: a concentrated ownership structure often transforms to lower valuation multiples. As the stock attracts more investors, especially institutional investors, the tendency is for a higher P/E multiple. However, good management knows how to utilize cheap valuations: buybacks. Besides, a long-term net buyer of stocks doesn’t want the share price to increase:
The sequence of a stock split:
- Announcement: After a rise in the share price, the board “suddenly” announces it wants to split the stock. The announcement draws attention and short-term investors are attracted. The share price goes up.
- Typical after an announcement, there is a pullback.
- Days before the split: When the split’s date comes closer, traders bid up the share price in anticipation of the split.
- When the split finally comes, more traders rush in to buy more shares. The ownership is thus dispersed.
- After some days and weeks, interest fades, and the split is forgotten.
A stock split changes the ownership structure:
What happens to the ownership structure after a stock split?
Martin Abrahamson and Robert Kalström studied stock splits in the Swedish markets (Stock split And Ownership) in a master dissertation called Stock splits and changes in ownership structures: evidence from Sweden. Their conclusions were:
Our results confirm positive abnormal returns surrounding the announcement of stock splits and stock dividends. Moreover, we find evidence on changes in owner-ship structure as well as number of shareholders. The results show evidence on decreasing ownership concentration due to the stock split, which implies a more dispersed ownership structure.
The authors conclude less concentrated ownership structure leads to higher valuation multiples.
However, we believe it’s safe to say a dispersed ownership structure means fewer knowledgeable shareholders. Furthermore, it attracts more shareholders that have a short-term mindset. Unfortunately, it’s difficult to implement long-term strategies when the shareholders are mainly concerned with how to maximize returns in the shortest amount of time.
A respected investor told me, “You end up with the shareholders you deserve”. I’m hoping that’s true……There is another class of long-term Constellation shareholders who invest time and effort to get to know our company and may even try to contribute to its growth and prosperity. We are fortunate to have a couple of dozen institutional investors, several hundred personal investors and several thousand employee shareholders who have taken this view.
– Mark Leonard, Takeaways From Mark Leonard’s Shareholder Letters
Why would long-term investors, who think like business owners, be interested in splitting the stock and attract the “wrong” shareholders? They are not, and neither is Warren Buffett:
Why Warren Buffet doesn’t want to split Berkshire Hathaway’s stock
Have you ever wondered why Warren Buffett and Berkshire Hathaway have never split their stock? The a-share of Berkshire currently trades at 342 000 dollars a share. 342 000 USD for one share! Needless to say, only a few can afford the a-share which carries more voting rights than the B-share which trades at 230 USD.
But Buffet is smart, logical, and rational:
Buffett understood early on the importance of attracting “quality shareholders”.
How does Buffett define a quality shareholder? That is a shareholder that thinks like an owner and own the stock for the long-term. This is a mindset that is shared, for example, in Markel, Alleghany, and Constellation Software.
All these companies have one thing in common: they spend a great deal of time and effort to attract quality shareholders. Their main tool is by writing an annual shareholder letter that seeks to educate the shareholders. For example, 90% of Berkshire’s shareholders voted against paying a dividend. Why did they vote against it? Because Buffett has written numerous times the advantages of letting the company’s earnings compound instead of paying a dividend and DRIP.
We have also written many articles about the pros and cons of dividend investing:
Moreover, Markel, for example, has an annual brunch in Omaha at the same time as Berkshire has its annual shareholder meeting. The sole purpose is that Markel wants to attract the same long-term shareholders as Berkshire has.
The argument is that less concentration of ownership and a higher degree of institutional owners are the main contributors to the excess returns over 1-3 years after a stock split. We believe stock splits perform better mainly because they have a better business. Remember what Benjamin Graham said: In the short run, the market is a voting machine but in the long run, it is a weighing machine. In the long run, it’s the business that makes a company valuable, not because it splits the stock and get a less concentrated ownership structure.
A rational shareholder base is an underrated asset of any company because it’s difficult to have the proper investment horizon without competent ownership.