Risk can be assessed

By DAVID MOON, Moon Capital Management, LLC
May 11, 2014

When gasoline first crossed the one dollar per gallon level in the US in 1979, fuel pumps could only accommodate prices up to 99 cents. Stations began pricing their gas by the half gallon. One day the price on the pump was 99.8; the next day it was 49.9, except that the second day’s price was for a half gallon of gas.

Everyone knew that dividing both the price and serving size of gasoline by two did not lower the price of fuel.

So why do people get excited at the prospect of a stock split?

When Apple recently announced its upcoming 7-for-1 stock split, many investors cheered. “A $600 stock is more expensive than an $85 one. When Apple’s price jumps $10 in a day, I’ll make $70 instead of ten.”

Wrong.

A stock split is simply financial theatre. Like removing our shoes at the airport or buying a cake mix that requires adding an egg, a stock split is merely an artificial exercise that gives the appearance of something substantive.

Investors invariably react as if a lower stock price somehow connotes inexpensiveness. But a stock price does not exist in a vacuum. It represents ownership in a business, and the value of that share depends on many things, including the percentage ownership of the business each share represents.

If stock splits create shareholder value, why doesn’t every company split its shares? Why doesn’t the Dow Jones Industrial Average cut itself in two?

Like most topics, you can find academic studies to support whatever opinion you hold. Some studies conclude that stock prices initially react favourably to news of an upcoming split, then otherwise trail the market for a period until those extraordinary gains are given back.

Other studies conclude there is no correlation between future stock price increases and planned splits.

Other studies claim that there used to be a relationship between stock splits and higher future returns, but not any longer.

An executive with one New York Stock Exchange traded company privately admitted to me that they regularly declare small stock splits, calling them “stock dividends,” simply in order to appease their shareholders who clamour for a dividend. The shareholders get a piece of paper saying they own more shares, even though their ownership in the company remains unchanged.

Sometimes companies wordsmith press releases in an attempt to even further sell the illusion. Here is actual language from one such press release.

(The business shall remain nameless because plenty of fine people in Knoxville work for the company—people who had nothing to do with this charade.)

“The board of directors has approved distribution to the common shareholders of a quarterly dividend payable in common stock at the rate of 1.8122 percent.”

That almost sounds like the shareholders are going to get something, perhaps even a 1.8 percent dividend. But no.

That sentence can be re-written as “we are going to give our shareholders worthless pieces of paper, because we think they are too stupid or ignorant to realize it’s a sham—a harmless sham, but a sham.”

Don’t fall for it.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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