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Share splits can add to a stock’s appeal, but it’s not reason enough to buy

share splits

Share splits may make a stock more attractive to many investors, but it takes more than that to make it a buy.

Share splits are when a company simply cuts itself up into a different number of pieces, without changing its fundamental value. It simply wants its stock to trade in a price-per-share range that seems reasonable to investors.

How share splits work

Mechanics of a split: If a stock’s price rises much beyond $50 a share in Canada (or $100 a share in the U.S.), some investors may shun it since it seems expensive. The company’s management may then declare a stock split of, say, two-for-one. This turns one “old” share into two “new” shares. If you owned 100 shares of a $60 stock, you now own 200 shares of a $30 stock.

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You don’t need to take any action. When you sell your shares and they get re-registered in the new owner’s name, the registrar will issue a new certificate for the proper number of shares.

With most conventional share splits, good news often follows. Companies mainly split their shares when they want to draw attention to themselves—because they expect earnings to rise faster than normal, say. At such times, they may also raise the dividend. However, sometimes companies get overly optimistic. Their profits come in far below expectations, and they can’t keep paying the new, higher dividend. So a sharesplit can be good or bad, depending on details.

Reverse share splits are typically followed by a fall in the share price

Splits in reverse: If the value of a stock collapses to pennies a share, investors may think it is headed for zero. To bring its share price back up to more respectable levels, the company may declare a reverse split: five, 10 or more ‘old’ shares will then turn into one “new” share. This ‘reverse share split’ is also called a “share consolidation”. This often happens to penny mining companies that have spent all their money without finding any valuable mineral deposits.

With reverse share splits, stock prices often fall back down again. Some investors sell because the stock seems more expensive than it was, even though a given holding represents the same percentage ownership of the company. Others sell because they fear the company will raise money by selling new shares, and this will drive down its stock price.

Remember, share splits or consolidations are just one detail. Don’t let them distract you from more crucial matters such as a company’s fundamental value and how well it suits your investment objectives.

Spin-offs, not share splits, are sure things

Some investors love share splits and rush to purchase them beforehand. While you may pick some winners, we feel that spin-offs are closer to a sure thing. A spin-off is when a division of a business spins-off into its own company. A number of studies have shown that after an initial adjustment period of a few months, spin-offs tend to outperform groups of comparable stocks for several years. For that matter, the parent companies also tend to outperform comparable firms for several years after a spin-off. That above-average performance makes sense for a couple of reasons.

First, company managers naturally prefer to acquire or expand their assets, not get rid of them. Getting rid of assets reduces a company’s total potential profit, which reduces the funds it has available to pay its managers. The management of a parent company will only hand out a subsidiary to its own investors if it’s fairly confident that the subsidiary, and the parent, will be better off after the spin-off than before.

Second, spin-offs involve a lot of work and legal fees. The parent will only spin off the unwanted subsidiary if it can’t sell the stock for what it feels it’s worth. That’s why companies only have an incentive to do spin-offs under two sets of favourable conditions: When they feel it isn’t a good time to sell (which often means it’s a good time to buy); or, when they feel the assets they plan to spin off will be worth substantially more in the future, possibly within a few years.

Oddly enough, many investors react to spin-offs as a nuisance, because they leave you with a tiny holding in a stock you didn’t choose and know little about. This is contrary to how investors feel about share splits. Both share splits and spin-offs can help you increase your wealth. But in general, share splits and consolidations are a minor investing detail. Don’t let them distract you from more important matters, such as a company’s fundamental value and how well it suits your investment objectives.

Have you invested in a company that has had multiple share splits? Did they work out for you in the long term? Share your experience with us in the comments section


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