A Splitting Headache!
And much ado about very little

by Ann Coleman (TMF

Reston, VA (February 2, 1999) -- Stock splits have a mystique about them! You hear such stories... he bought 100 shares in 1956 and today he has 10,000 shares. Wow! Stock splits sound like a good way to get rich!

Maybe magical is a better word to describe them -- magic as in "sleight of hand." Whatever else stock splits are good for, they do NOT build investor wealth except in a minor and peripheral way.

Yesterday we talked about what a share of stock really was. I mentioned that when a share splits, its price is halved, so nothing has actually changed. It's like getting two tens for a twenty. If the idea of two pieces of paper instead of one makes you feel better, then go ahead and get excited about stock splits.

One of the best examples of how stock splits don't build investor wealth is Berkshire Hathaway (NYSE: BRK.A), Warren Buffett's mega holding company that is selling for around $74,000 a share right now because Mr. Buffett doesn't believe in splitting shares. The company has also never paid its investors a dividend, preferring instead to use the cash it generates to buy other companies.

Obviously, buying a share of Berkshire Hathaway is not something done on a casual basis. But considering that the company has grown at something like 25% per year for the last several decades, most shareholders, especially those who bought in years ago, are probably quite happy with their few shares of stock -- although they may find it a bit tough if they needed to raise a relatively small amount of cash.

BRK.A is also a good, negative example of the "minor and peripheral way" in which stock splits help build investor wealth. When you restrict your "market" to those who have $70,000 to invest in a single company, you are obviously leaving out quite a few potential buyers -- and it's pretty safe to assume that NO ONE day trades BRK.A. Eventually, the lack of liquidity can get to be a problem. In fact, a couple of years ago, the company issued a new class of stock -- BRK.B -- which trades for a mere 1/30th the price of BRK.A. But don't call it a stock split, please!

The BRK.B shares brought the price of a share of this company down to a level that most investors could afford, were they inclined to throw their lot in with Buffett & Co. Now, Class A stock holders can convert a Class A share into 30 Class B shares and sell off just enough for the new Caddy. Most other companies head off this problem with stock splits. To the extent that liquidity and availability contribute to a stock's share price growth, splits can help build wealth.

The point here is that Berkshire investors' wealth was able to grow quite efficiently without stock splits. One can even make the case that frequent stock splits contribute to price volatility and ultimately harm the investor. Splitting a stock tends to encourage the misimpression that the stock has become cheaper, when in reality investors are just paying half as much money for half as much ownership. To whatever extent that that misimpression and the hype surrounding the split announcement contribute to the stock's price running up beyond a reasonable valuation point, the split could conceivably be the indirect cause of a later drop in price when investors realize that the price has gotten ahead of earnings.

[Hey, want to see my nominee for Dorkiest Corporate Website? Try Peter Lynch maintains that the best corporations are often those run from the worst offices. (The company officers are more interested in making money than showing off.) If you apply that theory to fancy websites, Berkshire Hathaway must top the list. If you want to learn an amazing amount about what it means to be an investor and shareholder, try reading some of that dorkily presented material. Start with the Owner's Manual.]

Although a split creates little more than volatility, here are some things you might want to know about the mechanics of a split:

First, when your stock splits, your cost basis for taxes splits as well. You can't claim, "Hey, I bought it at $10 and sold it for $10, so there's no capital gain," if you bought 100 shares and sold 300. Uncle Sam got wise to that one years ago. Your new cost basis would be 3.33 per share. Nice capital gain. Congratulations.

Stock splits are announced well in advance of the day that they actually take place, which causes massive confusion, usually for people who have made an honest effort to educate themselves. One reads about declaration dates and dates of record and split dates and various other arcane terms, which are basically irrelevant to everyone except the bookkeepers.

No matter what you've read about how you must be a shareholder of record as of this date in order to received the split shares, it's not true. From an investor's perspective, all you have to know is this: If you pay the pre-split price, you will get the additional shares. If you pay the post-split price, you won't.

You can't buy 100 shares for $50 each the day before a split and be stuck with 100 shares worth $25 each because the stock split. The additional shares may take a few days to show up in your account because they will bounce from the seller's account into yours, but all of the accounting, bouncing, and paperwork is handled by the brokers involved. You absolutely will not ever lose by buying a stock even moments before the split takes place. Unless of course, someone messes up --check your statements!

Fool on and prosper!

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Today's Stock Lists | 1998 Dow Returns

02/02/99 Close
Stock  Change   Last
CAT  -   3/8   43.31
JPM  -2  1/4   102.81
MMM  -1  1/8   75.88
IP   +1  3/16  41.19
                   Day   Month    Year   History
        FOOL-4   -0.47%  -0.33%  -2.41%  -0.96%
        DJIA     -0.77%  -0.91%   1.16%   0.76%
        S&P 500  -0.87%  -1.38%   2.98%   3.23%
        NASDAQ   -1.86%  -1.69%  12.35%  13.89%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   14 3M            73.57     75.88     3.13%
 12/24/98   24 Caterpillar   43.08     43.31     0.54%
 12/24/98    9 JP Morgan    105.51    102.81    -2.56%
 12/24/98   22 Int'l Paper   43.55     41.19    -5.42%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   14 3M          1030.00   1062.25    $32.25
 12/24/98   24 Caterpillar 1034.00   1039.50     $5.50
 12/24/98    9 JP Morgan    949.62    925.31   -$24.31
 12/24/98   22 Int'l Paper  958.12    906.13   -$52.00

                             Cash     $28.26
                            TOTAL   $3961.45