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Why do Stocks Split?

December 21, 2005 by Leave a Comment

Today’s topic covers stock splits: What are they and why are they done.

E-mail Question from Member:
Chris –
Here’s the question: I’m curious to know why some companies chose to split their stock (like HANS), while other companies chose to allow their stock to run (like GOOG). Is there any rhyme or reason as to why some managers chose to split and others don’t?

My Answer:
I will start by giving a brief definition of a stock split for those of you that are unfamiliar with the term. Every company that trades stock publicly has a set number of shares that are outstanding. A stock split is a decision by the company’s board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders. I will use Hansen Natural (HANS) as a recent example of a stock that split in 2005 while on our screens. I originally started coverage on the stock near $66 in May 2005 before a 2-for-1 stock split that took place in August of 2005. If you were to look at a current chart for HANS, the price in May 2005 would show you a number in the $30 range (half of the original price) due to the split. When a split takes place (in this example), every shareholder with one stock is given an additional share. So, Hansen Natural had approximately 11 million shares outstanding before the split and it now has 22 million shares outstanding after its 2-for-1 split. If you owned 100 shares near $90 when it split, your account would be adjusted to 200 shares near $45.

As investopedia.com states: One share represents the value of the company’s underlying assets plus its growth potential divided by the number of outstanding shares. After a stock split, the only value that changes is the denominator in the equation. After a split, the stock price will be reduced since the number of shares that are outstanding is increased. In the example of a 2-for-1 split, the share price will be halved.

So why does a company want to split its stock?

Most individuals and small investors believe that a stock is more affordable at a lower price and they will only buy if the stock seems reasonable. Currently, Google is trading above $400 per share; so many investors will not buy this stock because they believe it is too expensive. In all actuality, 100 shares at $400 are the same as 400 shares at $100. Buying Hansen at $100 per share in August was actually cheaper than buying it now at $83 because the $83 is actually worth $166 before the split. Another reason for a split is a clue to the market that the growth in the company is expected to last (this is an assumption that the company’s directors make when asking for the split). When the board decides that a stock should be split, they send a voting ballot to every shareholder to make the final decision. I have voted in these ballots and ironically, the first stock I ever bought in my life split 2-for-1 (I thought I was important because I had a say in the stock).

Some stocks have split two or three times in one year (especially if you go back to the heart of the 1999 bull run) and some stocks don’t like to split such as NVR (a home building stock), Google and the most famous: Berkshire Hathaway, owned by the second richest man in the world (Warren Buffett). The current price for BRK-A is $88,600 with a 52-week range of $78,800 – $92,000. To buy 1 share on the open market today would cost you $88,600.

So, a stock split is used primarily by companies that have seen their share prices increase substantially. A stock split increases the number of outstanding shares and therefore decreases the price per share. This helps makes the shares more affordable to small investors and provides an indicator of the health of the company.
Piranha

Filed Under: Education

Trade for Real

August 11, 2005 by 2 Comments

…I read a comment by a forum member on another site earlier today that suggested that every investor should back test their system for at least twenty years. I disagree and will now tell you why. Back testing and paper trading seem to be the most over emphasized techniques offered by market theorists, educational elite, market novices and/or market fakes. While learning the pure basics, I can see why a novice investor may want to paper trade; to see the results of the developing system but I will warn that these results are completely false. The results will not contain the emotional decisions that go along with risking your own cash. Anyone and I mean anyone can paper trade successfully. It’s simple, place a trade and hope it goes up and if it doesn’t, you have no worries because you can’t lose. The emotional imbalance that occurs when you really start to lose money is not present. Don’t fool yourself by believing the results of your paper trading or virtual simulation portfolio. These things may give you some confidence in your system but they don’t prove a damn thing in the real world. The real world, specifically the stock market, is run by emotional human beings. People make decisions that are irrational and base their trading decisions on fear and greed. Paper trading lacks fear and greed because there is no gain and no loss; therefore there is no consequence to deal with.

Don’t worry about back testing for 20 years because historical back testing is never very accurate. The most accurate testing is real time. If you can back test real trades (actual trades that you have made in the past), then this would be just as good as real time testing (or forward testing). Back testing can get you somewhat of an idea of how your system will perform but there is no emotional attachments to this type of testing so it is not realistically accurate. We all know emotions are tied to our decisions in the markets so we can only get accurate results through real testing. Learn to ignore the talking heads and the people on TV and that internet chat room that claim they are up over 1000% trading a fake account. What really makes me laugh is the person that sets up a virtual trading scenario and then allows each participant to trade $500,000 or more in their account. If you are going to trade a fake account, at least keep it real so you try to learn something, maybe money management.

I setup one virtual trading competition a few years back and I only allowed each participant to start with $10,000, a reasonable amount, an amount that most people start trading with. The competition was fun but it was not real for me or the others. I didn’t care what risks I took and I never had a problem pulling the trigger which does happen in real life. I did try to keep my trades in line with my real life account but it varied slightly. I witnessed other traders making 20 trades per day or 20-50 trades per week. This is not real because the commissions alone, even with a discount broker will wipe you out. I did allow margin because I use margin in my account but I saw other investors abusing the fake power of margin in their virtual account, again, playing the game for fun instead of learning something valuable. As a fellow investor, keep testing your system in real time and you will know what works and what doesn’t based on real trades, not simulations. Professors and the like teach theories while investors actually do the trading! Back testing may convince some people but I am only convinced with what works now, in real time. Besides, why would I waste my time playing for fake money when I can learn and do for real? Back testing may be good for some people but I have been testing my systems in real time since the day I started investing seriously. Currently, I am testing the $60-$100 theory using options in my newest account. I will not have concrete data on this system for another year or two, most likely two years down the road. I could back test the system but how will that help me realistically going forward? It won’t, it may show me some probabilities and the possible expectancy of the system but it won’t guarantee anything until I place a position for real.

If you want to test a system, open an account with real money, even a minimal amount and give it a try. Make sure you use enough money to allow emotions to be attached to your decisions. Without the emotional attachment, you are cheating yourself and your potential system.

Filed Under: Education, Psychology

A Common Misconception about Stock Prices

February 22, 2005 by Leave a Comment

…I cringe every time I hear a novice investor tell me that they only purchase low priced stocks because they offer higher potential gains. A common phase I hear is “I like to buy $1 and $2 stocks because they can double easily and I will make a 100% profit”.

My reaction is to always let these people know that “stocks are priced low for a reason, just as stocks priced high are there for a reason”.

Like anything in life, quality is never offered at a discount. When I am in the market for a car, I don’t expect to purchase a Mercedes for the price of a Pinto. No pun directed towards Pinto car owners as I am just providing an example.

Stocks are valued at their current market value or perceived value under the current situations. A $1.00 stock is trading at this level because it is only worth this much in investor’s eyes. A stock priced at $50 or $100 is trading at these levels because of a quality that the lower priced stock does not have. Institutions, such as mutual funds, will not purchase a stock at $1 based on strict internal rules and fund guidelines. Stocks, similar to the ones on our All-Star list move based on vast amounts of support from institutions that have the buying power to propel prices 100%, 200% or more in less than 12 months.

A quick study of stock market history will prove that the majority of stocks priced at $2 or less will be de-listed or bankrupt before they ever give an investor a triple digit return. High quality stocks are typically representative of high quality companies that usually have innovative products or services that are increasing revenues and earnings thus peaking institutional interest. I have seen more stocks double or triple from the $20-$50 range than any other price level during the past five years.

A stock going up 25% in one month’s time is the same whether it is from $5 to $6.25 or $60 to $75. It happens every year. The novice investor is usually hesitant to buy a stock that is priced at $50 or more as it looks too expensive to the untrained eye. What’s expensive to an uneducated investor may be a bargain to an educated investor.

Always buy the stock that presents the highest probability of success based on both fundamental and technical analysis. The price should never matter nor should the lot size. A 25% gain will always be the same whether you buy a $2 stock with 5000 shares or a $100 stock with 100 shares.

I agree that the chances for a quick 25% gain on a $5 stock seems greater than a 25% gain for a $100 stock but it’s also much greater for a 25% slide on the $5 stock than it is for the $100 stock. Your downside protection is limited with a low priced stock as it can move quickly and present you with an illiquid position that a higher quality stock may not present.

Here is a very basic example:
If you buy a $2 stock and it gains $1 in two months, you now have a 50% gain. But, if the stock falls $1 in two weeks, you now have a huge 50% loss in your portfolio, a number that usually devastates most traders.

If you buy a $60 stock and it gains $30 in two months, you will have a 50% gain. Now, if the stock starts to fall rapidly and is now down $10 in a few days, you still have a chance to sell the stock within 10% of your purchase price and prevent further loss and devastation to your portfolio. You, the investor will most likely be able to spot negative action or red flags and get out quickly enough without the sudden 50% drop that the lower priced stock could blindside you with.

Don’t buy a stock based on low prices or a quantity of shares. Always buy a stock based on quality looking towards the fundamentals and technicals and the price and volume action. Study our archives and look at the number of stocks that have gone on to tremendous gains from the $20, $30 and $40+ levels.

As you can see on every weekly screen, we don’t discriminate against $10 stocks or $100 stocks. We list every stock that has the highest potential to present a gain.

Piranha

Filed Under: Education, Psychology, Wall Street
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