Wednesday, July 23, 1997
The Mythology and
Psychology of Stock Splits
by
[email protected]
My wife and I were sitting at the McDonald's annual meeting a couple of years ago. It's a gala event, attended by hundreds and Michael Quinlan's style is to have his lieutenants all make brief presentations about their individual areas of responsibility. It's my understanding that most Chief Executives make the lion's share of comments at stakeholder's meetings, and Mr. Quinlan's delegation of the microphone adds to the event.
He does, however, save the significant moments for himself. One of those moments is an announcement that is widely anticipated, the decision to increase dividends. His announcement of the increased dividend was met with solid applause. The second moment is another event that's hugely anticipated by shareholders, any decision to split the stock price. Apparently Mr. Quinlan consults with his mother on the best timing for this, and he shared the essence of this discussion while introducing his new grandchild, who Grandma was holding in the front row. There we have it. Great Grandma Quinlan decides when to split McDonald's share price. This was met with a thunderous ovation and cellular phones clicked with "buy" orders for MCD. When the raucous applause settled, Quinlan also observed that the McDonald's board had just voted to buy back a significant amount of McDonald's stock.
Dead silence. We looked at each other in puzzlement, because our newfound interest in investing suggested that this was probably the most rewarding announcement of the three. Were we missing something? We hear it all the time. "Intel's gonna split next week -- buy." This is probably among the most common misperceptions among investors and it's an epidemic. Just what is a stock split? Purely and simply, it's an accounting function that has almost no bearing on the stock value. At our MCD meeting, we were simply being told that instead of 100 shares at $60 ($6000), we now owned 200 shares at $30 ($6000). A value analysis performed before and after a stock split will be identical; that is, our expected value for the stock will not change. It's not a better deal at $30 than $60. There is, however, an element of psychology at work here and some basic economics.
The psychology is wrapped up in the perception of forward-looking value for the stock. In general, it's widely believed that only strong companies split their stock prices. A company wouldn't want to split from $40 to $20, and then watch the price drop toward zero. A stock split promotes a perception of committed strength, and stock traders take advantage of the momentary surge and retreat in the stock price, before and after the announcement and transaction. To a long-term investor, though, it's just a bump on the yellow brick road. The drop in price will attract smaller investors, creating a temporary surge in demand, which also helps to pump up the "bump."
Let's recap the announcements: (1) The increase in dividend. This increases our dividend yield, and our expected return. Call it "Good." (2) The stock split doubles our shares, with no long-term change in value or benefit. In fact, the increased number of shares probably means higher transaction costs because commissions are often based on number of shares rather than the amount. Where's the long-term benefit to us? Score it "Meaningless." When was the last time Berkshire Hathaway split? (3) The stock buyback. This means the company will increase the value of the stock, increasing earnings per share by driving down the number of shares outstanding. This will increase our expected return for the stock. It's also a suggestion [not always valid] that management sees their own stock as one of the best investments that they can make at the time. Add it all up, and it seems that this was the most powerful announcement. Maybe "Great?"
My wife and I were among the few that participated in the smattering of applause that accompanied announcement #3. I'd be willing to bet that the other hands coming together belonged to other Foolish investors in the crowd.
Mark Robertson