The Investment Perspective – February 2022

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

Stock Splits – Good Or Bad?

Key Points:

• When are stock splits good?
• When are stock splits bad?
• What large well known business is about to split its stock?

Stock splits are a technique used by generally large successful and growing businesses to achieve one or more objectives.

Why Stock Splits?

Some companies undertake stock splits so that they can be included on an index such as the Dow Jones. The Dow Jones, because of its price weighting mechanism, does not include companies with high-priced shares.  That’s why Apple engaged in a 7 for 1 stock split in 2014 and was then added to the Dow Jones in 2015. 

Other companies like to split their stock because lower-priced stocks are generally more appealing to a greater number of people. In fact, many investors reason that a share price at $5 must be better value than another share price at $2,000.

The idea is that a $5 share price has much further to rise than a $2,000 share price. This can be true but is not true because the price is lower. It is true for other reasons, such as the fact that the $5 per share may well be a Small Cap with plenty of room to grow, but also has a strong business model and developing economics.

Sometimes, companies undertake a share split to appeal to a broader range of buyers.  That creates demand which in turn pushes the trading price up. That increases the total market capitalization of the company too, which those businesses like.  

Another reason for a stock split is that, in theory, it signals that good prospects lay ahead for a particular company. 

Whilst any number of those reasons outlined above can be valid, they are not the type of initiatives that we as e-Biz Investors pay much heed to. That’s because they are very much a “play the market” mechanism that may well have some impact on the trading price in the short term but ultimately lack any real fundamental merit.

The bottom line

So, the bottom line is that stock splits are quite common and seen as a positive by markets.

However, we as e-Biz Investors actually are not that keen on stock splits because it means that there are more shares on issue and that effectively, our ownership is somewhat watered down. Not only that, it costs the company more money to administrate those additional shares. 

You may have worked out already, that a stock split is in some ways is the opposite of a share buyback. 

A share buyback is where a company uses retained earnings (in some cases, they even borrow money which can be less of a good idea) to buy back shares that are sold on the market and then remove them from the market.

This means that remaining shareholders automatically become a bit richer because they own a greater percentage of the pie with those shares that are sold, bought back by the company and removed from the company’s on market share registry. 

The number of shares on issue decreases, which means that the intrinsic value per share increases.

Existing shareholders, as I said, all get a little bit richer without any additional investment.  That is the bottom line.

Therefore, at WISEplanning we prefer share buybacks to stock splits. 

Perhaps one note worth mentioning is that some people don’t like share buybacks, and this can be because sometimes, companies undertake these share buybacks when the trading price is high.  Granted, it’s not the best idea to be using resources and paying a premium to buy back shares. 

For those companies that borrow money to undertake share buybacks, whilst generally, that appears to be a questionable approach, providing the level of debt is reasonable with low-interest rates and the business can use capital at a higher rate over time (make more money than the interest paid), it actually makes sense to use debt to buy back shares.  

That way, whilst there are servicing costs because of the debt, with low-interest rates, those servicing costs are minimal hopefully compared to the performance of the business and long-term growth, making everybody richer along the way.

Alphabet stock split

Alphabet (Google) just split its stock. You may be aware that Alphabet has recently announced a 20 for 1 stock split. 

Basically, this means that once this transaction is finalised that Alphabet shares will trade a lot lower than they do at the moment. Each share of Alphabet common stock trades at around US$3,000 per share. 

This does not mean that you have lost money with the lower share price, because you will own an increased number of shares.  They just trade at a lower price to offset the increased number of new shares.  

Fundamentally, it really makes little difference to the long-term fortunes of the business.  However, from a “play the market” perspective, a lower trading price may mean that a broader number of investors may go for Alphabet, which can help push its trading price higher in the near term. 

The stock split announcement a few days ago was on the back of a strong earnings report where revenue growth of 32% year on year was announced by Alphabet. 

So, owners of Alphabet stock will receive their additional shares around July 15 this year, when the trading price will drop and trade at a lower price as the additional new shares are added to the market.

Frankly, I’m not keen on the idea because it costs money and in my opinion is simply window-dressing.  Of little value fundamentally for us as investors in the long run. 

Price or value?

The trading price of Alphabet has doubled since May 2020 and is now trading at a price taking total market capitalisation to just under US$2 trillion.

Amusingly, I see reports in the media stating that the company’s value has more than doubled since May 2020. Actually, the intrinsic value of the business has not doubled.  

What has happened is that the trading price has doubled. As you know, the trading price and the intrinsic value are not the same thing. 

I know you’ve heard this before. 

I mention it again because it might be useful for some investors to remember this point when markets become volatile as those rate hikes unravel over 2022. 

“There are no shortcuts to any place worth going”.

Proverb