The Easiest Way to Waste $1 Million

Here's a question we get every time we tell somebody about a stock idea: "What's the share price?"

It's a fine question -- share price, after all, is a good starting point. And according to research from Georgetown University (go Hoyas!) professor James Angel, our answer would be "somewhere in the low $30s" -- the average price of stocks listed on the NYSE.

But get this
What was the average NYSE share price 50 years ago? Somewhere in the low $30s. You read that right: The average share price has remained almost unchanged for decades. Thanks to stock splits, the average NYSE share price stayed between $31 and $32 per share from 1943 to 1994, even as the market itself rose more than 1,500%.

C'mon now
The price of a stock is a necessary piece of information if you hope to buy shares. But it's ultimately an unimportant detail.

We're always confounded by this reaction: "A $100 stock? Too pricey for me."

But why? Because you only have $90 to invest?

OK, OK
Yes, because of historical conventions, we've learned to associate certain characteristics with stock prices. Stocks trading for less than $5, for example, are generally considered penny stocks and should probably be avoided.

But aside from that and how many shares you'll be able to buy with your $1,000 lot, stock price can't tell you a darn thing.

Yet because of splits, the average stock price has remained unchanged for decades. Consider a handful of other oddities, all borrowed from Professor Angel's essay, "Tick Size, Share Prices, and Stock Splits."

  1. Stock splits are cosmetic -- your capital remains the same while the number of shares you own changes. Yet research has shown that stocks increase after splits and decrease after reverse splits.
  2. The idea that companies use splits as a signal of good things to come is refuted -- they're used more for restoring prices to "a normal range."
  3. Stock splits are costly -- for large firms, the costs run in excess of $1 million.
  4. Before the NYSE changed its method of quoting stocks from a percentage of par value to dollars, stock splits were rare.

So why, then, do companies split their stocks at all? Back in 1997, Professor Angel hypothesized it was in order to maintain efficient tick sizes -- or the increments in which stocks are traded. By doing so, companies could ensure that bid/ask spreads were minimized and trades in their stock were executed efficiently.

Now, we can all appreciate a market with a little less friction, but does that benefit outweigh the costs? And more importantly, how many investors actually know that that's the only good reason to split a stock at all?

Price is not the same as value
So why do companies keep splitting their stocks? Who knows. It's an expensive process with few, if any, tangible benefits. Yet we've become socialized to think most stocks should trade at $30 per share and, more dangerously, that stocks that trade at less than $30 will get to $30 eventually.

Nothing could be further from the truth!

Just take a look at these stocks and their share prices, P/E ratios, and expected five-year growth rates.

Company

Recent Share
Price

Recent
P/E

Expected Five-Year
Growth Rate

Wal-Mart (NYSE: WMT  )

$48.48

18.3

13.0%

IBM (NYSE: IBM  )

$98.99

16.3

11.0%

Caterpillar (NYSE: CAT  )

$67.67

13.1

14.5%

Sprint Nextel (NYSE: S  )

$18.97

46.1

8.0%

Qwest Communications (NYSE: Q  )

$8.45

28.1

5.0%

Symantec (Nasdaq: SYMC  )

$17.95

40.5

11.6%



You can see the $40-or-more stocks are cheaper on a P/E basis and have as much or more potential upside according to Wall Street analysts.

What a stock price tells you: almost nothing
A stock's price tells you nothing other than how many shares you can buy. Price is simply a function of equity value/shares outstanding.

Warren Buffett has famously refused to split Berkshire Hathaway. Not once. That's why A shares trade for nearly $109,000. Berkshire could trade for $10 if Buffett did a 10,710:1 split.

But what would have changed about the underlying business? Absolutely nothing! In fact, it would have cost Berkshire a not-insignificant sum of money to split those shares -- and that's money that Buffett wouldn't be able to plow back into making his company grow.

Signing off
That is why, when investing, you should focus on a business, not a stock price. And while small stock prices can tell you nothing about an investment's prospects, it is true that companies with small market caps are more likely to have huge upside.

We focus on small-capitalization companies at our Motley Fool Hidden Gems service. But instead of caring about a low stock price (our recommendations currently sport an average stock price of about $40 per share), we focus entirely on fundamentals. That includes finding companies that have:

  1. Management with an ownership stake.
  2. Strong balance sheets.
  3. The ability to generate cash.
  4. Dominant positioning in a profitable niche.
  5. Plenty of room to grow.

Taken together, our recommendations are beating the market 54% to 23% on average. And one of our favorite companies that meets all of these criteria is Middleby, a cooking equipment maker that's returned more than 500% since its recommendation in 2003 and now trades for more than $100 per share. And trust us, that's still not "too pricey."

If you'd like to learn more about our methodology and recommendations at Motley Fool Hidden Gems, as well as our favorite small caps for right now, click here to join our community free for 30 days. There is absolutely no obligation to subscribe.

Tim Hanson owns shares of Berkshire Hathaway. Brian Richards does not own shares of any company mentioned. Berkshire, Wal-Mart, and Symantec are Inside Value recommendations. The Fool's disclosure policy stands firmly behind Jeff Green for Big East Player of the Year.


Read/Post Comments (0) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

DocumentId: 522728, ~/Articles/ArticleHandler.aspx, 4/21/2014 3:40:06 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement