<FOOLISH FOUR PORTFOLIO>
Adjusting Your Splits
And, one more time, what is a share?
by Ann Coleman
Reston, VA (April 5, 1999) -- Will it? Won't it? As I write, the Dow is skittering back and forth across that magic 10,000 line. Will it close above or below? You'll know the answer by the time you read this. Presumably you will know that this crossing, if it crosses, is no more significant that the one a couple of weeks ago, which was good for champagne sales, but not much else.
Oh, OK, I'll get just a little bit excited. May as well have some fun -- any excuse for a party! More important than silly numbers is the continued strong economy, low interest rates, and sunny optimism that seems to be pervading Wall Street these days. Of course, it never hurts to remember that it's always brightest just before dark... or something like that.
Our Foolish Four portfolio is looking good today, but since we didn't tear our hair out last week when it slipped behind the Dow and the Standard & Poor's 500 Index, I guess we shouldn't jump up and down when it rallies, either. Next December will be soon enough to start cheering, and sometime around 2005 would be even better.
I used the term "split-adjusted" last Tuesday without much explanation. Since every other stock you read about seems to be splitting these days, perhaps a bit of elucidation may in order.
Most historical quote services and all charts use split-adjusted prices. Otherwise, the chart of Microsoft (Nasdaq: MSFT) would show that, periodically, the stock price dropped by half overnight. That might give a false impression of the company's actual performance.
It's easy to say that when the stock splits, the previous prices are also split, but it's actually a bit more profound than that. What is really happening is that the price is adjusted to reflect what you (any theoretical owner) actually paid for each share of stock that you now own.
Think of ice cream -- a nice half-gallon brick, frozen hard. You buy it today for $4. Tomorrow, the company announces that they will be splitting their packages of ice cream two for one. From now on they are only going to sell quarts for $2 each. Your half gallon is actually 2 quarts, right? Each quart is worth $2. Two bucks is your split-adjusted price for a package of ice cream. Two bucks is also what you paid for each quart of ice cream when you bought the half gallon. You didn't necessarily think of it as buying two quarts, but those future quarts were contained in the half-gallon you bought.
Now suppose you bought the ice cream and put it in the back of the freezer, and two years later (we are ignoring freezer burn, here) you find that the price of your half gallon has doubled and at some point between then and now the stock has split. You go to the store and see that the price of that brand is still $4. (I hope you noticed that the package is only half the size.) Your ice cream at home is worth $8, because it is now two shares instead of one. You can take a very big butcher knife, run it under the hot water tap for a minute, split your brick of ice cream into two shares, and sell each for $4. Quick -- what's your split-adjusted purchase price for each "share"?
Right. Two bucks.
This gets really, really important when tax time comes around. Uncle Sam only wants to hear about the split-adjusted price. I used to get very amusing letters around this time last year when I was doing Foolish Customer Service. Folks were wondering about their Schedule D. Could they put down that they bought 100 shares at $50 a share and they sold 100 for $55 a share, they wonder? Well, yes, the shares were split twice, and they still have 300 shares, but those were truthful numbers -- and the tax was ever so much nicer that way.
In the first place, Uncle Sam doesn't care about the share price, he wants to see the "cost basis." That is what it cost you to buy the shares you are selling -- usually the split-adjusted price times the split-adjusted number of shares with purchase commission added it. You can't explain that you didn't really make a profit because you paid $4 for some ice cream and sold some ice cream for $4 when you only paid $2 for the portion of the ice cream that you actually sold. (And I hope you held it for at least a year and a day so that your capital gain is taxed at the long term rate. More on that tomorrow.)
Most of the confusion arises from the slippery definition of a "share" of stock. Come to think of it, the whole concept of a "share" causes no end of trouble. People think that a $100/share stock is more expensive than a $25/share stock without even considering that one may represent a gallon and the other a half-pint. They get all excited because their stock split and now they have 200 quarts when just yesterday they only had 100 half gallons! And then there are the penny stock players who think that 10,000 shares of nothing is better than 10 shares of Microsoft.
We need a better name.
How about amoebas? They slither around and change shape, and people generally recognize that when they do the binary fission thing, they end up half-size.
Well, maybe not. Best to stick to single syllables for words that get shouted frequently in the trading pits. Got any ideas?
Fool on and prosper!
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Stock Change Last -------------------- CAT +2 1/8 49.06 JPM +1 5/16 125.81 MMM + 1/4 73.00 IP --- 43.50
Day Month Year History FOOL-4 +1.55% 3.77% 6.72% 8.30% DJIA +1.78% 2.26% 9.38% 8.95% S&P 500 +2.12% 2.70% 7.79% 8.05% NASDAQ +2.67% 3.99% 16.75% 18.36% Rec'd # Security In At Now Change 12/24/98 9 JP Morgan 105.51 125.81 19.24% 12/24/98 24 Caterpillar 43.08 49.06 13.89% 12/24/98 22 Int'l Paper 43.55 43.50 -0.11% 12/24/98 14 3M 73.57 73.00 -0.77% Rec'd # Security In At Value Change 12/24/98 9 JP Morgan 949.62 1132.31 $182.69 12/24/98 24 Caterpillar 1034.00 1177.50 $143.50 12/24/98 22 Int'l Paper 958.12 957.00 -$1.12 12/24/98 14 3M 1030.00 1022.00 -$8.00 Dividends Received $15.04 Cash $28.26 TOTAL $4332.11
</FOOLISH FOUR PORTFOLIO>