How to Use Stock Splits to Build a Winning Portfolio

May 24, 2013, 5:29 p.m. ET

How to Use Stock Splits to Build a Winning Portfolio

By MARK HULBERT

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The price of Noble Energy NBL -1.15% shares will be cut in half this coming Wednesday, when the oil-and-gas-exploration company’s previously announced 2-for-1 split goes into effect. This will follow close on the heels of two other companies whose stocks this past week also fell because of 2-for-1 splits: consumer-products company Colgate-Palmolive CL +0.33% and A.O. SmithAOS -0.10% a water-heater manufacturer. In fact, so far this year 25 NYSE or Nasdaq National Market companies have split their shares by 2 for 1 or more, according to data provider Mergent. The number of such companies has been rising steadily along with the bull market; for all of 2009, for example, there were just 12 such splits. Should you change your opinion of Noble Energy, or any of these other companies, just because they split their shares? It is difficult to see why you should. A 2-for-1 split, for example, merely means you now own twice as many shares that are worth half as much. But try telling that to Neil Macneale, editor of an investment-advisory service called “2 for 1,” whose model portfolio contains only those stocks that have recently split their shares, holding them for 30 months. Over the past decade, according to the Hulbert Financial Digest, that portfolio has produced a 14% annualized return, far outpacing the 8% gain of the Standard & Poor’s 500-stock index, including dividends.Mr. Macneale’s track record isn’t a fluke. Several studies have found that the average stock undergoing a split outperforms the overall market by a significant margin over the three years following the company’s announcement of that split. Indeed, Mr. Macneale said in an interview, he got the idea for his advisory service in the 1990s from one of the first such studies, conducted by David Ikenberry, now dean of the Leeds School of Business at the University of Colorado, Boulder.

One of the leading stock-split theories—supported by the work of professors Alon Kalay of Columbia University and Mathias Kronlund of the University of Illinois, Urbana-Champaign—is that companies implicitly have a target range for where they would like their shares to trade.

If a firm’s shares are trading well above that range, and management believes that this high price is more than temporary, it is likely to initiate a split in order to bring its share price back to within that range.

The professors late last year completed a study of all U.S. stocks that split their shares by a factor of at least 1.25-to-1 between January 1988 and December 2007. They say the evidence their study uncovered suggests that splits are an “indication of sustained strong earnings going forward.” It therefore shouldn’t be a big surprise that split stocks outperform other high-price stocks that don’t undertake a split.

One corollary of this theory is that it would be a bad sign if a company were to “reverse-split” its shares—a process in which the number of shares outstanding is reduced, with their price commensurately increasing. That would suggest the company is confident its shares won’t soon rise enough to get back into an acceptable trading range, and that is the consistent finding of several past studies.

All this suggests that two companies announcing reverse splits this past week will face stiff headwinds over the next couple of years: electronics manufacturer Pulse ElectronicsPULS +1.65% which announced a 1-for-10 reverse split, and home builder William Lyon HomesWLH +1.26% which announced a 1-for-8.25 reverse split. The companies didn’t respond to requests for comment.

Investors looking to profit from the stock-split phenomenon should shun stocks that have undergone a reverse split and focus instead on those that have split their shares. You will have to invest in such stocks directly because there is no mutual fund or exchange-traded fund that bases its stock selection on stock splits.

Fortunately, constructing a portfolio of such stocks needn’t be particularly time-consuming.

For example, there is no need to guess in advance which companies are likely to split their shares—which in any case would be difficult, if not impossible, to do. There even appears to be no need to buy a company’s stock immediately after it announces a split, since research shows that it is likely to outperform the overall market for up to three years following that announcement.

Still, Mr. Macneale recommends that investors be choosy when deciding which post-split stocks to purchase. He cites several studies suggesting that the post-split stocks that perform the best tend to be those that, at the time of their splits, are trading at relatively low price/earnings or price/book ratios. Both are commonly used measures of a stock’s valuation, with lower readings indicating greater value.

That is one of the reasons why, among recently split stocks, he passed overMaximusMMS -0.49% a health-care company that announced a 2-for-1 split in April. It sports a trailing 12-month P/E ratio of 26 and a price/book ratio of 4.5, versus 19 and 2.5 for the S&P 500.

Mr. Macneale also advises investors to be diversified when investing in post-split stocks, rather than betting all-or-nothing on just a couple of them or becoming overly exposed to just a couple of industries.

For example, he said that right now he would probably be purchasing Noble Energy, with a P/E of 21 and a price/book ratio of 2.2, were it not for the fact he already has several energy stocks in his portfolio.

His most recent purchase was Home BancSharesHOMB +0.95% a bank that also announced a 2-for-1 split in late April. It has a P/E ratio of 18 and a price/book ratio of 1.8.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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