Synopsis
- Apple reported a very strong first quarter for 2014, and they also announced a 7-for-1 stock split which will lower the stock price from close to $565 per share to approximately $80.
- Although stock splits may sound like a value creating event for shareholders, they neither add nor destroy value, but the psychology behind them can often create more demand for the stock.
- The Investment Committee is rarely interested in stock splits. However, this split is encouraging because large value investors may finally take notice of a cheap, shareholder friendly stock.
One Benjamin for Five Jacksons
As nice as it is to have a $100 bill in your wallet, this denomination is notoriously difficult to use on a daily basis because many merchants will not accept them. Therefore, it's usually best to take that $100 to a bank and exchange it for five $20 bills.
Similarly, as desirable as a high stock price sounds to a management team, this situation can also create hassles (admittedly this is a high class problem). Therefore, companies will often engage in a "stock split" to reduce the price of their stock by half or sometimes even multiples lower.
A stock split is a corporate action that increases the number of shares by dividing each share, which in turn diminishes its price. The stock's market capitalization, or the overall value of the equity, remains the same much like the value of the $100 bill is not altered by swapping it for five $20 bills.
For example, with a 2-for-1 stock split, each shareholder receives an additional share for each share held, but the value of each share is cut in half. If the shareholder owns 50 shares of a $100 stock for a total of $5,000 ($100 x 50 = $5,000), the investor would now own 100 shares of a $50 stock for the same total of $5,000 ($50 x 100 = $5,000). Simply put, the value of the equity has not changed.
Although a stock split may seem pointless given the value remains the same, companies still do them for three key reasons:
- Increased Liquidity: By increasing the number of shares available for purchase, the liquidity for that stock will rise. Increasing liquidity will result in lower costs for trading. For example, Berkshire Hathaway (ticker: BRK-A) has never split their stock and is now trading at close to $190,000/share. Since only a few hundred shares trade daily, the cost to buy the stock is substantially more expensive than a highly liquid stock where millions of shares trade daily.
- Marketability: A lower stock price makes that equity more attractive to smaller investors who want to own more than a few shares. For example, most smaller investors cannot afford to buy BRK-A simply because the cost for one share is often prohibitive and/or undiversified.
- ESOPs: An Employee Stock Option Program (ESOP) is designed to pay employees with company stock, and a lower stock price allows management more leeway to pay its employees.
The bottom line is that companies split their stock because much like that $100 bill, there are operational and psychological advantages to keeping the stock price lower.
NOTE: Companies can also elect to do a "reverse stock split", which actually increases the value of a stock but reduces the number of shares outstanding. Companies will typically conduct reverse stock splits to meet the exchange listing requirements. For example, a stock listed on the NYSE that has fallen to $0.50/share may announce a 1-for-10 reverse split to boost the price to keep the stock trading at $5.
Apple's Stock is Splitting
Apple reported their most recent quarterly results this week, and their numbers were quite impressive. Furthermore, they also announced an 8% hike in their dividend and increased their stock buyback program by $30 billion. The Investment Committee applauds these shareholder friendly activities and continues to see a strong investment case for owning the stock.
They also announced a 7-for-1 stock split, which will bring their share price from around $565 to approximately $80. This split is Apple's first since 2005, and many investors are asking why they chose to split their stock now.
Apple explained its decision to split the stock very simply: "We want Apple stock to be more accessible to a larger number of investors." This response falls directly inline with our reasons above, however, there appears to be more to the story.
The Investment Committee, along with the broader institutional investor community, believes that Apple is positioning itself to be included in the Dow Jones Industrial Average Index (Dow), which is one of the most popular equity indexes in the world.
The Dow is a price-weighted index, which means that high-priced stocks have a bigger impact on the index. A $500+ stock would have an outsized impact on the index price, so it would not be considered for inclusion. By contrast, Apple would fit well with an approximately $80 stock price.
A stock that gets added to indexes like the Dow or the S&P 500 will often rise in price in anticipation of big institutional investor buying. For example, a mutual fund that tracks the Dow is usually required to own every stock in the index, so if Apple were to be added to the Dow then this manager would need to add Apple's stock to their fund.
Simply put, increased institutional investor demand for Apple's stock could cause the value of the stock to rise even further.
Implications for Investors
While the logic above is sound as stock prices typically do rise when added to indexes, we are less optimistic about the impact to Apple given that the Dow is not as popular as the S&P 500 or Russell indexes for the majority of institutional managers.
Rather, we believe that inclusion into the Dow is important because it is a further indication that Apple is no longer a growth company, and value investors should take notice.
The Dow index typically represents mature companies that are more shareholder friendly than younger companies more focused on growth. Inclusion in the Dow could act as a psychological trigger for those value investors that still struggle to believe that Apple is nothing more than a damaged growth stock.
The bottom line is that although stock splits seem like nothing more than breaking a $100 to get five $20 bills, we are encouraged by Apple's decision because big investors may finally take notice of a company that is printing money, growing its already attractive dividend, buying back $130 billion of its shares, and is "stupid cheap." Stock splits may do nothing to the value of firm equity, but Apple was wise to make this move and hopefully more long-term value investors will now realize the opportunity in this stock.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser.