This is a holy juncture. Christians are celebrating Easter while Jews are celebrating Passover. These festivals strengthen and reassert faith, but they do so in large part by questioning it.
At a less profound level, self-questioning can be good for an investment portfolio, not just for the soul. So let’s take this opportunity to question one time-honoured ritual of equity investing: stock splits. What is the point of them?
Stock splits are meant to keep a share price at a manageable level. A two-for-one stock split involves replacing every outstanding share with two, and making no other changes. It is a complicated operation (although not wildly expensive), whose only effect is to halve the nominal price of the shares.
The habit is ingrained. General Electric’s share price at the end of 1935 was $38.25. Exactly 70 years later, it was $35.05. According to research by a group of academics from the University of California at Los Angeles, Cornell University and the University of Chicago*, GE would by this point have traded at $10,094.40, had it never paid stock dividends or split its stock.
I once interviewed a nonagenarian US investor, who had started his portfolio during the Depression. He tallied the success of his investments by the number of shares he had 60 years later, rather than by their value – so much was it taken for granted that companies would split their stock to keep the nominal price at about $40.
No constituent of the Dow Jones Industrial Average has a share price of less than $19, or more than $95.
In the UK, people like the nominal price of their shares to be even lower. Prices are quoted in pence, not pounds. No constituent of the FTSE 100 has a share price of more than 2,680p or less than 310p.
There are obvious disadvantages. Splits get in the way of comparisons of share price performance over time (although decent data providers can overcome this).
Sometimes they are self-defeating. Lucent Technologies probably wished it had not bothered to keep its share price at a “manageable” level after it was caught up in the collapse of the internet bubble. For years, until its merger with Alcatel of France last year, its share price stood at about $2. It almost always had the highest volume of shares traded on the New York Stock Exchange.
This is important, because stock exchanges and other intermediaries charge fees based on the number of shares traded, rather than on the amount of money that changes hands. So splitting stock increases costs for investors. The researchers from Cornell and elsewhere found that GE investors would have saved 99 per cent in brokerage commissions if it had not split its stock. About 5bn GE shares traded in 2005, so this is equivalent, they say, to about $100m.
Are there good reasons for this? None stand up to examination. One is that there might be an “optimal” trading range, at which individual investors can afford to buy a round number of shares. But this should logically at least have risen with inflation, so that average nominal prices now would be 10 times their level of the 1930s. In any case, individuals mostly now hold stocks through mutual funds, which don’t find high share prices a deterrent.
Another possibility is that there is an effective minimum ratio between the “tick” size, or spread between bid and offer prices, and the share price. Below a certain ratio, on this argument, nobody will be prepared to make a market in the stock.
The problem here, the researchers point out, is that exchanges have introduced decimalisation in recent years, in place of fractions. This helped to reduce the average tick size from $0.125 per share to about $0.01 over the last decade. But instead of falling by more than 90 per cent, as this theory would predict, average share prices stayed the same.
A final argument is that a low share price, in spite of the attendant costs, signals to investors that a company is of high quality. But a low share price can be embarrassing and the researchers found splits tend to come just as earnings have peaked – not at a time when companies need to send out positive signals.
So has anybody had the nerve to go against the orthodoxy? They have, and their identity is revealing. Warren Buffett, the world’s most successful investor, has never seen the point of stock splits. A share of Berkshire Hathaway, his main investment vehicle, will cost you $100,000. This has not harmed demand for the stock over the long term. Beyond the Buffett empire, the two highest share prices belong to the Chicago Mercantile Exchange (which has been as high as $593) and Google (which has been as high as $513), the two most successful stock market debutants of this century. Neither has felt any need to bring its share price down to a lower level, and neither has been punished for this by investors.
So this is one case where questioning faith leads to a surprising result. Despite a century of dogma, companies should not split their stock, and investors should not reward them when they do.
*Working Paper: The Nominal Price Puzzle, by Shlomo Bernatzi, Roni Michaely, Richard H. Thaler and William C. Weld, University of California at Los Angeles