Why only 2 for 1 splits?

Our monthly recommendations come from a list of stocks that have split 2 for 1 during the previous calendar month. Readers have asked why we don’t include stocks that have split 3 for 2 or by some other formula. This seems a reasonable question when one considers that a 3 for 1 split, for instance, might be considered an even more positive signal than a 2 for 1 split. Our procedure is based on two considerations.

The first and easiest to explain is that the entire 2 for 1 strategy and procedure relies on a Rice University study that looked at only 2 for 1 splits. We thought it best to stick with the group of stocks cited in the study, rather than make an assumption that the same findings would apply to stocks outside that group. It may be that there is a correlation, but we have not done the work that would be needed to prove this to ourselves.

The next, and just as important a reason, is that the number of stocks splitting 2 for 1 is more than enough to provide several good companies to choose from each month. Remember, we only need one! Doing the research and sifting through the 37 stocks on the list this month was time consuming enough. Why would one want to make the list any longer? To this some might say, “but what if the most promising stock split 3 for 2 instead of 2 for 1?” You can only know this after the fact, and one need only look at the many very successful stocks that we have passed up to realize that our odds would not have improved by simply making the pool we picked from larger. The success of our portfolio does not depend so much on the selection of individual winners as it does on assembling a group of stocks that has a slightly better than even chance of beating the market.

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The 2 for 1 Procedure

Faced with the list of splits on the previous page, how does one go about choosing the single company to buy this month. First of all, it’s not an exact science. If you rely on the basic 2 for 1 assumption that this group of stocks will do slightly better than the market as a whole, you could pick a company off the list blindfolded and have a better than 50/50 chance that it would do all right. It is our feeling, however, that even these good odds can be improved.

We start by eliminating the companies that are too small or too thinly traded. It has also been shown that very inexpensive stocks are often split by their management only to draw attention to the company, not because the board feels the company’s prospects are promising. We would take a hard look at any stocks selling for less than $15.

At this point, personal preferences and “hunches” begin to play a larger role. We sort the remaining group of stocks based on dividend yield, Beta, PE ratio, and price to book ratio and try to find a company that scores well on all those lists. But we also look at the portfolio as a whole and try to diversify by industry and size. For this month, there are several companies we could have gone with. Kimball, Pacific Century Financial, AK Steel, Florida Rock, Pitney Bowes, U.S. Restaurant Properties, and Selective Insurance Group all made it to the short list. We believe anyone can build a successful portfolio using these methods. If you enjoy making the final selection, we will supply you with the list of splits and you can do the research. If you want to leave it to 2 for 1, we will continue to recommend the company that we will be adding to our own portfolio.

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We Like Dividends

Picking stocks because they pay dividends is becoming an outdated concept, it seems. It was not always so. Did you know that in the earlier part of this century people bought stocks because, overall, they paid higher dividends than the interest available on bonds? Utility stocks were always the favorites of “widows and orphans” because of income provided by the almost guaranteed generous dividends. No more. Companies are now using excess cash for stock buybacks, acquisitions, or market investments for the company’s own portfolio. Anything to avoid paying that money out to the shareholders. And frankly, in many cases, the companies are correct in their strategies because they can often get a higher return on the excess cash than the individual shareholder could in the market.

But 2 for 1 still likes companies that pay dividends for several reasons. Taking the balance at the start of the year, our portfolio had a 1997 dividend return of 2.28%. Historically this is not great but it is significantly better than the approximately 1.6% dividend return for the S&P 500. This 2.28% provided the bulk of the margin by which we beat the market last year. So, all other things being equal, our portfolio is going to continue to beat the market just based on the dividend return. In addition, when there is a major correction (read CRASH) in the coming months or years, we feel that our dividends will provide the cushion that will help the 2 for 1 portfolio beat the market by even bigger margins. And finally, we believe companies that pay dividends are companies that remember for whom they are working. It is not the only factor in our stock picking process, but we will continue to favor companies that pay dividends.

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An Exception

As noted in the article on page one, this month’s stock buy came from the July list of splits rather than the August list. To clarify and explain this apparent divergence from our normal procedure, let’s look at what we are actually trying to accomplish with our monthly stock selection. The ultimate goal of the 2 for 1 procedure is to maintain a portfolio of 30 stocks that moves through time; the company at the top of our list being 30 months old and the one at the bottom being our most recent purchase.

All of the stocks come from the group that has declared a 2 for 1 split in the weeks preceding our selection. We use this group because a Rice University study by David Ikenberry and several colleagues showed that, collectively, this group is expected to outperform the market by a measurable amount for a 2 to 3 year period. We make our group dynamic by buying and selling one stock each month, thereby constantly refreshing the portfolio with “new blood” and selling off the “mature” stocks. We believe it doesn’t make much difference if a stock is purchased 3 weeks, 6 weeks, or 10 weeks after the split is announced, as long as the intent is to hold the position for 2 1/2 years.

In this case, only ten companies announced 2 for 1 splits in August and of those ten, none had fundamentals that came close to matching those of the stocks that we have been buying over the last year or so. To expand the August pool, over half of the July list (the 2’s, 3’s and 4’s) were added to the August list and all were compared using updated fundamental information. Of the group from July, we included on the ranking list only those that scored a #3 or better in the revised ranking.

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