Stock Split Theory Confirmed

For those who have been following 2 for 1 since the beginning, you know that we base our stock picking on the theories tested by David Ikenberry and colleagues of Rice University. A discussion of this working study was publicized in the April 22, 1996 issue of Forbes magazine. Now, apparently, the final version of this study has been published by professor Graeme Rankine, one of Ikenberry’s colleagues, in the Journal of Financial and Quantitative Analysis. The study’s findings, based on a sample of 1275 companies that split between 1975 and 1990, are in agreement with the original working paper; namely that stocks split 2 for 1 do better than the market by 8% in the year following the split and 16% better, on average, over the three years following the split.

In a recent article in the Los Angeles Times, Jon Markman quotes Rankine. “Our research showed that even if there appears to be a reaction following a split announcement, it’s actually an under-reaction. There are, on average, more gains to be had after the stock actually splits.” Markman writes that “splits, more often than not, are blazing neon signs erected by the boards of the nation’s fast-growing companies to declare that even better times are expected ahead.”

The Times article also discusses a four-page report by analyst Timothy Alward of Ford Investors Services which talks of average annualized gains of 32.3% if all the stocks that split in a month are bought and then sold three months later. The article does not state whether this method takes transaction costs into effect. Obviously, transaction costs would be vastly higher under this method than with the 2 for 1 method with only 2 transactions per month.

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Personal Finance Tips

Your 2 for 1 newsletter attempts to be informative and helpful regarding your stock market investments. However, we are narrowly focused, by design, and it would behoove any investor to become educated in a wider range of topics related to management of personal finances. The following suggestions are both for those who are just getting started with their investments and for those wanting to keep abreast of the world of business and finance.

For the best overall source of financial information, we recommend subscribing to the Wall Street Journal in print or on the Internet. Information on companies, big and small, is thorough and timely and it is not all written for experts. Jonathan Clements’s Tuesday column “Getting Going” is always one of our favorites. The Journal takes a bit of time to wade through every morning, but if you don’t need a daily sports page, this paper has better, more condensed coverage of world events than most of our major dailies.

Forbes magazine has been on my nightstand for many years. I have gained insight into countless topics from the columnists in Forbes, including the idea for starting this newsletter. Ken Fisher, David Dreman, Mark Hulbert and the “Streetwalker” column are my favorites. In a recent issue, Ken Fisher listed three phone numbers for catalogs of financial publications. 800-575-9255 will get you a “Financial Insiders Catalog of Wall Street Creations”. 800-272-2855 is for “Traders’ Library Catalog” and 800-927-8222 will bring the “Traders Press” catalog. There should be plenty here for anyone wanting to further their knowledge and, of course, there is always the public library.

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How Risky is 2 for 1?

The quality of an investment should be judged not only by its total return, but also by how much risk is incurred while owning it. Risk, in the stock market, is often measured by the “Beta” of a security. Very simply stated, this is a measure of how much a stock price bounces up and down compared to the market as a whole. We thought it might be interesting to compare the 2 for 1 portfolio to the market and, if you will struggle through the statistics with us, we’ll try to highlight what we found.

If the S&P 500 and 2 for 1 had grown evenly each month since January 1990, they would have grown 1.66% and 2.45 % respectively each month. We have taken the actual change each month for both lists and compared it to the above numbers to establish the absolute difference between this “norm” and the actual. The standard deviation from the norm for the S&P over that time was 2.23 percentage points while the 2 for 1 portfolio standard deviation was only 1.97 points. If one looks at the short term since the “real” portfolio was started, the standard deviation is 2.11 and 1.37 points respectively. These comparisons show that our portfolio has been less volatile than the market as a whole, measured by the S&P 500.

If one equates volatility with risk, then it would seem to follow that, so far, both in the test and the real portfolios, our stock positions as a group are less risky than the market as a whole. Intuitively, we believe this to be true, if only because the companies we recommend tend to be the less flashy, “steady as you go” type businesses. This result, together with our long term “laddering” approach to the market, gives 2 for 1 a very tolerable overall risk level.

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Starting this month, there will be a ranking attached to each company in the 2 for 1 split list, as seen in the column to the right. It would be possible to dish up lots of statistics, graphs, and analysis of every company on the list, but that could fill many pages and all that information is generally available elsewhere. It is thought the “value added” that 2 for 1 can provide is a better distillation and conveyance of the results of the sorting and screening process used to make our choice each month.

To keep it simple and save space, a ranking system has been put in place that will allow a reader to put all the companies into perspective relative to the company selected to go into our portfolio. The numbers to the right of each listing are derived by a proprietary formula weighing several factors. Among these factors are P/E and book to value ratios, dividends, trading volume, capitalization, and several others. Each month one stock will be ranked number 1 and number 2. From that point, there may be several 3’s, which we would consider good prospects, the 4’s would be the “run of the mill” group, and the 5’s would probably best be chosen only if you know something we don’t know. There may be several stocks with the NR (not ranked) designation. These would be companies that we can’t get enough information on or that are so small and/or thinly traded that we don’t feel comfortable recommending them to a large number of investors.

We hope that the new ranking system will be helpful to those of you who want to evaluate other choices rather than following our recommendation every month. We will continue to look for ways to make 2 for 1 as useful as possible to you, our readers.

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Market Mysteries – The Split Process

By far the most common question that I get on the phone or through the 2 for 1 Web Site is in regard to the dates, language, and actual mechanism of accomplishing the stock split. When a board of directors decides to split the company’s stock, they decide on several dates and other issues. They decide on a “record date”, the “payable date”, and when they will announce the split. They also decide whether the split will be 2 for 1, meaning the owner will get one additional share for every share they already own, or some other ratio such as 3 for 2, 5 for 4, etc.

For the typical 2 for 1 split, the sequence goes like this. The split will be announced, usually immediately following the board of directors’ meeting. The announcement will include the record date, usually several weeks to several months in the future, and the payable date, usually several weeks after the record date. On the record date, the company makes a list of all owners to determine who will receive the split shares. On the payable date, the company will deliver the new shares to all parties on that list. (The ex-dividend date is the date the shares begin trading at their new price on the various exchanges.) If an owner sells stock between the record date and the payable date, the shares go with “rights” that entitle the new owner to the split shares. The only difference is that, in this special case, the shares will be delivered to the new owner by the broker/dealer rather than the company itself.

When all is said and done, the value of shares owned, bought, or sold is not effected by the split. What the split does do is give us the signal that the board of directors (the insiders) are very optimistic about the long term prospects for their company.

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Indexes, Funds, and 2 for 1 – Tough Times

The last quarter of 1998 and the first quarter of this year have been marked by the phenomenon known as a “narrowing” of the market. In a nutshell, the market indexes are showing good gains, but more and more, these gains are being driven by a smaller and smaller number of high flying large cap stocks. These numbers are hiding the fact that the majority of listed stocks, NYSE, AMEX and NASDAQ, are down over the last three months.

Let’s look at the universe of publicly traded mutual funds as a way to understand the performance of the 2 for 1 “fund”. In the first quarter of ’99, only one of the ten broad categories of funds tracked by Morningstar managed to beat the S&P 500. That was the group of 450 “Large Growth” funds; the funds holding Microsoft, AOL, etc. Meanwhile, the S&P MidCap 400 index was off 6.38% for the quarter and the Russell 2000 index was down 5.43%. Morningstar’s 227 funds in the “Small Value” group dropped an average of 9.77% over three months.

Because 2 for 1 holds stocks in both large and small categories, we didn’t do as badly as the two indexes above, but that is small comfort when our goal is to beat the S&P 500. We can only hunker down and wait this phase out, knowing that the pendulum swings both ways. We own good companies that make profits and pay dividends. The 2 for 1 stocks will have their day.

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