Banana Splits
Why stocks splits are all the craze right now
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The hip and cool trend for budding companies used to be free lunch and ping pong tables. This was secretly a trap to keep employees at the office longer so they never had to leave for lunch breaks.
There’s a new trend for these up-and-coming companies that is a retail stock investor trap instead of an employee trap…
Stock splits.
There have been so many freezing cold finance takes on TikTok when it comes to stock splits, but at the same time, the Finance 101 rulebook has also been stumped.
Mathematically, it makes no sense for a stock price to go up after a split, but we are not in rational times.
Some companies famously do not split their stock as a way to gatekeep the shareholder base. Others are here to try anything they can to get volume into the stock.
This week, in <5 minutes, we’ll cover stock splits:
What they are 👉 More slices of the same pie?
Why they are done 👉 Retail investor, Liquidity rationalizations
Company examples 👉 Tesla, Shopify, Walmart, Not Berkshire (Kind of…)
Let’s get started!
1. What they are 👉 More slices of the same pie?
A stock split is when a company increases the number of its shares in order to attempt to boost liquidity. This increase in share count has a corresponding share price effect that lowers the price per share by the same multiple that increases the number of shares outstanding.
For example, if a stock is trading at $100 per share with 1 million shares outstanding, the market capitalization (value of the company assuming no cash or debt) is $100 million. A 10:1 split would have the new shares worth $10 per share, but with 10 million shares outstanding, leaving the market capitalization unchanged, at $100 million.
Although the number of shares outstanding increases by a specific multiple, the total dollar value of all shares outstanding remains the same, because a split does not fundamentally change the company's value.
Fellow pizza lovers out there know that pineapple doesn’t belong on pizza, but they also know that no matter how many times you slice a pizza, it does not change the amount of pizza.
Say you have a 14” diameter pizza and slice it into either 4 slices or 12 slices. You can eat 1 of the former or 3 of the latter and the amount of pizza consumed will be the same.
So why do it?
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2. Why they are done 👉 Retail investor, Liquidity rationalizations
The top reason that actually might make sense is that by reducing the share price of the stock, more investors can buy it. This is targeted at retail investors who are more sensitive to the share price than institutions.
Let’s take the example of someone who is just starting out in investing and follows the GRIT mantra of dollar-cost averaging and buying stocks with excess savings every month. If that excess saving is $500/month, you cannot afford 1 share of Amazon, because 1 share of Amazon costs over $3,000. One share of Nvidia, on the other hand, costs around $220, so you can buy two of those.
Since stock price movements are dictated by the price equilibrium of buyers vs sellers, the rationale that some people might give is that by splitting the stock, you increase demand because you increase the number of retail accounts that can purchase one stock. But…
This is a bullshit reason because most retail investing accounts now allow fractional share purchases, so instead of having to save up for 6 months to buy 1 share of Amazon, each month you can buy 0.1667 shares.
Another reason companies will give for stock splits is that it will increase the liquidity of the issue. The higher number of shares outstanding can result in narrowing the bid-ask spread. Increasing the liquidity of a stock makes trading in the stock easier for buyers and sellers.
Liquidity lets traders and investors buy and sell shares in the company without too great an effect on the share price. That can help companies repurchase their shares at a lower cost since their orders would not move up the share price of a more liquid stock as much.
This reason I can agree with.
Before we continue, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!
3. Company examples 👉 Walmart, Tesla, Shopify, Not Berkshire (Kind of…)
Walmart
To look at the effect of stock splits over time, let’s start with a company that has been around forever and loves stock splits. Walmart split its stock 11 times on a 2-for-1 basis between the retailer's stock-market debut in October 1970 and March 1999.
An investor who bought 100 shares in Walmart’s IPO would have seen their share count grow to 204,800 shares over the next 30 years without any additional purchases.
Tesla
Tesla re-sparked the topic of splits back in August 2020 when they announced a 5-for-1 split. The stock traded up 12.6% that day just on the split announcement.
Talk about nonsensical.
I understand that Tesla is a retail darling and splitting the stock would theoretically attract more retail investors, but to me, this argument doesn’t hold any water.
The institutional interest in the name makes up a big percentage of the shareholder base due to large ETFs buying it because of its market cap (north of $1 trillion). The retail argument also doesn’t hold because of fractionalized shares which I mentioned earlier.
Surely this was a one-off. Nope.
A couple of weeks ago, on March 28, Tesla announced they were asking shareholders for permission to split the stock again in the form of a dividend that would pay them additional shares.
The stock in the pre-market? Up 8%…
Shopify
For Shopify, we’re going to go a little beyond just the concept of splits because they’ve been doing a bunch of things lately:
As much as I’ve been a fan of Shopify from the start, I’m going to have to agree with the points Bucco made in this tweet. Earlier, Tobi Lütke Tweeted out this:
To me, this missed the mark completely. I don’t think CEOs should be checking their stock price and losing sleep over it. The role of the CEO is to run the business.
But the stock price is also critical over the long term when it comes to two components: financing future growth through the ability to go back to the equity markets, and employee stock-based compensation to retain top talent.
After this tweet, Lütke then comes out with a massive change to Shopify’s compensation package whereby employees can elect to take their bonus in cash rather than equity. This is all amidst a plummeting background where all growth stocks entered a steep selloff period.
He then announced a 10-for-1 stock split at the same time as a much more concerning feature: giving himself a different class of share that gives him supervoting power. Under this new class of shares that he has issued Lütke will control approximately 40% of voting power despite only owning roughly 7% of the common shares of the company.
This has been common in other founder-led companies which can lead to less ambiguity when it comes to strategic direction, but it also overly insulates these founders because they will now need substantial unification amongst the remaining shareholder base for any other decision to be overturned.
Interesting times ahead for SHOP, it’s all on Lütke’s shoulders (which has paid off handsomely in the past).
Berkshire Hathaway
If you were to read about the storied Warren Buffet in the early 1990s and think, “Hey, if he’s the best in the biz, why not just buy his company’s stock and let it ride?”
Well, the answer for a lot of people was pretty straightforward. You can’t afford it. The stock traded up around $30,000 for a single share at the time, and unless you were to look at unit trusts that were Berkshire look-alikes the entry point was just too high.
This was done by design. By nature, the Oracle is a long-term value investor and wanted his shareholder base to be the same. He was not worried about short-term liquidity. Nor was he worried about appeasing to retail investors who, rightly or wrongly, were perceived to have much shorter time horizons which introduced volatility.
However, he would eventually create a second class of shares, the class B shares, available for 1/30th the price in 1996, followed by a 50-to-1 split for that class which sent the ratio to 1,500 Class B shares for 1 Class A share.
He did this because too many unit trusts were deceiving retail investors and charging egregious commission fees.
Wrapping Up…
Ultimately, stock splits should have no mathematical impact on the valuation of a company, yet they do because the perception is that the stock is now more accessible to the retail community.
I think this is a microcosm of the overall environment we currently find ourselves in. We have been in a period where we have had historically low-interest rates which leads to easy justification when it comes to high multiples.
When looking at a stock price you have: fundamental x multiple (sentiment) = stock price.
When so much of a company’s value is buried in the “multiple” this leads to an environment where telling a story is more important than a quarterly earnings report. Investors are buying the story for future growth.
Stock splits tell a story. That's why people love them and bid the stock up.
Do with this information as you please.
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
P.S. Have you subscribed to our *NEW* CRYPTO NEWSLETTER?
What else we Grittin’ On?
PPI. The producer price index rose 1.4 in March and 11.2% YoY, both records. Final demand goods led with a 2.3% increase.
EXPECTATIONS. Public expectations for March 2023 inflation hit a record 6.6%. February's 6% was the previous record.
STOCK SPLIT. Shopify has proposed a 10-to-1 stock split. The company is also proposing a 'founders share' to protect CEO Lutke's voting power.
CARBON-FREE. Google has plans to use 100% carbon-free energy in its data centers by 2030. CEO Pichai calls it 'humanity's next big moonshot'.
AD REVENUE. Digital ad revenue jumped 35% in the US last year. That's the biggest gain since 2006.
Sources:
https://www.investopedia.com/ask/answers/021615/why-doesnt-warren-buffett-split-berkshire-hathaway-stock.
https://www.cnn.com/2022/03/28/investing/tesla-stock-split/index.html
https://www.cnbc.com/2022/04/11/shopify-plans-a-10-for-1-stock-split-eyes-founder-share-to-protect-ceos-voting-power.html
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