Greater Than the Sum of the Parts

Friday Reflections | August 21, 2020

Greater Than the Sum of the Parts

“You better cut the pizza in four pieces because I’m not hungry enough to eat six.”

-Yogi Berra

This week offered devastating reminders about non-market risk as wildfires rage in California, with many households impacted directly and indirectly by this destructive recurrence. The week also offered speeches about the future of our country and democracy at the Democratic National Convention, and major stock indexes climbed back to pre-pandemic levels. The juxtaposition of elevated risk levels versus optimistic market prices can feel at odds for some investors as the world evolves into new business practices and ways of life amidst the ongoing pandemic.

This week also saw new highs for current market darling, Tesla Motors. The company makes innovative electric vehicles, has an eccentric CEO, and in most quarters hasn’t been profitable. None of this is new. The only new item is that Tesla recently announced they will be doing a 5-for-1 stock split at the end of August.¹ Only a few weeks earlier, Apple similarly announced that they will be completing a stock split for the fifth time in their company’s history,² and have also seen their share price outpace the broad market since their announcement. This leads to two questions: what is a stock split? And why are investors so excited when it happens?

If you order a large pizza and cut it into 12 slices instead of 6, the pieces get smaller but there isn’t any more or less pizza. You can, however, share the pizza more easily. This is the basic premise of a stock split. The price of any stock is determined by taking the total value of the company as estimated by analysts and investors, and dividing by the company’s number of shares.If a company is worth $100 and they have 10 shares of stock, then each share is worth $10. If that company does a 2-for-1 split, then each investor now gets 2 shares worth $5 each instead of 1 share worth $10. This price moves daily based on shifting estimates of the company value and resiliency of their future earnings, but at the most fundamental level the price is value divided by shares.

So, why would a company decide to cut their stock or their pizza into smaller pieces? The answer is that they are trying to get additional price growth by taking advantage of investor psychology and decision-making processes that aren’t wholly rational. History shows that it works.

As the price of a stock increases, some investors, particularly smaller ones, may view the shares as too expensive and out of reach. A split makes each share more affordable, even though the overall size of the pizza hasn’t changed at all. This creates an effect where investors may feel like they have an opportunity to buy the stock at a lower price and investor appetite can surge. For example, to buy Tesla at $400/share rather than $2,000/share, even though you are only getting 1/5th of what you would have gotten pre-split.

In two separate studies at the University of Illinois in 1996 and in 2003, David Ikenberry found that price performance of split stocks outperformed the market by 8 percent during the year following the split and by 12 percent over the ensuing three years. He looked at over 1,000 stocks for each study, including 2-for-1, 3-for-1 and 4-for-1 stock splits.³ However, the benefit over the long-term is more muted and a separate study showed that stock splits increase the price volatility of shares substantially.⁴ Companies that pursue stock splits generally have high earnings and price growth that already outpaces the broader market. Regarding any price impact, positive or negative, it is important to recognize that the stock split itself isn’t the whole explanation.

Much of classical economic theory starts with a premise that individuals faced with financial choice will make rational decisions aligned with their best interest. Modern economists have questioned this presumption of ‘rational actors,’ even before witnessing the irrational refusal of many individuals around social distancing and mask protocols. The truth is that market prices are a sum of decisions made by investors who, in turn, are human. As humans we have a number of cognitive biases and predictably irrational behavior patterns.

One cognitive bias that is relevant to the investors’ response to a stock split is called ‘anchoring’. According to Harvard Law School, the “anchoring effect” is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions.” In the stock split example, investors have an anchor that Tesla is worth $2000/share or that Apple is worth $500/share. When they see prices at lower levels post-split, say $400 for TSLA or $125 for AAPL, they are biased to believe that price should be higher and that the current price is therefore at a discount. Again, the true value of the company and the shares hasn’t changed, only the price.

As company prices move higher, they may evaluate stock splits as an option to attract more retail investors sensitive to share price, and to signal that they believe in the continued growth of their company. Some people speculate that Amazon may be next in line, as the price of a single share has climbed above $3,200/share. They split one time in 1999, but not since.  Google is another candidate at roughly $1,600/share.

Warren Buffett is a legendary investor, and shares in his company Berkshire Hathaway have beaten the broader market dramatically over the last fifty years. They have never split their stock price, and the original shares now trade for $311,126. Buffett believes that “the high share price attracts like-minded investors, those focused on long-term profits rather than on short-term price fluctuations.”⁵ Only in 1996, when investors threatened to create vehicles to them to buy in at lower prices, did Berkshire opt to create a second class of shares at a lower price. Currently, the B shares trade for 1/1500th the value of the A shares – or $207.43.

Buffett’s example illustrates that the hopeful tailwind of a split isn’t a good reason alone to buy a stock, and success over the long term comes from fundamentals. The estimated value of the company, its future growth prospects, the health of its industry, and your circumstances as an investor must all be considered. When prices change dramatically – whether a stock split due to rapid company growth, or widespread movement like we saw in March – the best approach is usually to stick with the allocation you made at a more rational, calm moment.

The biggest driver of growth over time in an investment portfolio is not the creation of a plan, but rather the ability to be disciplined enough to stick with that plan through price volatility. Having a steady strategy allows you to focus more on what’s important in your own life. That may be educating your children, developing new skills, or simply staying safe with family.

¹ https://ir.tesla.com/news-releases/news-release-details/tesla-announces-five-one-stock-split

² https://investor.apple.com/faq/default.aspx

³ Ikenberry, David L., Graeme Rankine, and Earl K. Stice. “What Do Stock Splits Really Signal?” The Journal of Financial and Quantitative Analysis 31, no. 3 (1996): 357-75.

⁴ A 1985 examination found that stock splits boost the deviation of shareholder returns from their historical mean by 30% and that the effect was unchanged a year after the split.” https://pointsandfigures.com/2012/05/25/stock-splits-winners-or-losers/

⁵ Troy Segal and Gordon Scott, “What’s the Difference Between Berkshire Hathaway Class A and Class B Shares?” Investopedia, updated March 16, 2020.