If you’re looking for signs of irrationality in the current stock market, and you’re not one of those people who think that every Internet stock out there is necessarily overvalued, the best place to look is probably the investor craze for companies that announce stock splits. When a company splits its stock, it does so by offering its current shareholders one (or sometimes two or three) shares for every one they currently own. The value of the company as a whole stays unchanged, although its stock price is cut in half (or in thirds or fourths). In essence, a stock split divides up the company’s pie into more slices, without changing the size of the pie at all.
Stock splits are a legacy of the time when it was difficult for individual investors to buy shares in anything other than round (that is, multiples of 100) lots. If your stock got too expensive, it was hard for individual investors to buy it, but if you split your stock, you could bring those investors in. That rationale has evolved–or devolved–into a vague idea that investors would rather own more shares at a lower price rather than fewer shares at a higher price, even though the value of each holding is the same (1,000 shares at $12 = 3 shares at $4,000).
Vague and inexplicable as this idea is–all an investor needs to care about is the percentage return on his or her investment–there is a grain of truth in it. Take, for instance, the difference between Microsoft, which routinely splits its stock when the price climbs comfortably above $100 a share, and Berkshire Hathaway, Warren Buffett’s company, which has never done a stock split.
Berkshire Hathaway’s Class A shares now trade at around $80,000 a share, while its Class B shares trade at around $2,000. That means there are millions of investors who will never consider buying the stock and, in the case of the Class A shares, probably couldn’t buy the stock. And, since stock prices do reflect supply and demand to a certain degree, that’s kept Berkshire Hathaway’s stock price lower than if it had split as often as Microsoft’s. Conversely, Microsoft’s stock price is almost certainly higher than it would have been had it rejected stock splits (in which case its stock price would be even more stratospheric than Berkshire’s).
So, all other things being equal, stock splits do exert a slight upward pull on a company’s stock price. But slight is the key word here. Academic studies suggest that the shares of companies that announce stock splits don’t do significantly better than the market, which makes sense, since in the long run a stock’s price is determined far more by the underlying value of the company than by any other factor. And a stock split has nothing to do with underlying value.
You often hear that splits are important because they’re a way for management to signal that it’s confident in the company, but this is a non sequitur, unless not splitting the stock is a way of saying, “We don’t believe in our future, so we don’t want small investors to be hurt.” And in any case, splits have become so routine, and in some sense so expected, that any signaling function they might have had has been vaporized.
Despite all this, the announcement of a split now regularly drives up a company’s stock price. A week and a half ago, for instance, Juniper, one of the hottest back-end Internet companies, announced a 3-for-1 stock split, and its shares, which were already remarkably expensive, rose 16 percent. There was no other news. This was it. The company’s future prospects were no better at the end of the day than they had been at the beginning. But the market thought the company was $2.3 billion more valuable.
What we’re seeing here is a classic recursive loop, in which meaningless news becomes meaningful because the market has established a pattern of treating similarly meaningless news as meaningful. More than that, an entire cottage industry has sprung up around stock splits, since investors are now able to receive e-mails and beeper messages telling them that a given stock has split. And the existence of that industry itself conveys the message that splits are important, even though they aren’t.
Any time you have a phenomenon like this one, it’s better to look for the underlying economic rationality rather than just write it off as hysteria. But in this case, the market really isn’t recognizing hidden value by rewarding stock splits. It’s just shuffling money from one pocket to another. And the really weird thing is this: When Juniper announced its stock split, its shares were trading at $284, and they then leapt to $328. In other words, investors don’t seem to be deterred anymore by high stock prices. They’re happy to pile in, whether the stock costs $20 or $200. In their reaction to the stock split, then, investors demonstrated that splitting isn’t really necessary to bring traders in. And so the world turns. On its head.
