Broker Check

That’s A Big Burrito.

March 22, 2024

I love the feeling of $100 bills in my wallet. It’s purely psychological, and I can’t explain why, but it just does it for me. However, large bills are impractical because many merchants will not accept them, and they don’t work well for small purchases.

High stock prices can cause similar challenges for companies and investors. For example, Berkshire Hathaway (ticker: BRK.A) is $626,910/share and averaged just over 300 shares traded daily prior to 20221. This makes transacting more difficult and expensive versus a stock that trades more.

Furthermore, a mere 5% allocation to BRK.A requires a portfolio of over $12 million ($626,910¸ 5% = $12,598,200). If an investor wants to buy exactly $150,000, they are out of luck unless the broker offers “fractional shares,” which is the ability to purchase part of a share of stock.

Management can also face challenges paying its employees in stock. For example, if an employee earned a $2,500 bonus to be paid in stock, but the stock is $3,000/share, they may have a problem.

Corporate boardrooms occasionally split their stock to alleviate these issues. A stock split is a corporate action that increases the number of shares and reduces its price. The stock's market capitalization, or the total value of the equity, remains the same. It’s no different than swapping a $100 bill for five $20 bills at the bank. The number of bills in a wallet rises, but the total value of cash remains unchanged.

For example, a 2-for-1 stock split adds an additional share for each share held, but the value of each share is cut in half. If a shareholder owns 50 shares of a $100 stock for a total of $5,000 ($100 x 50 = $5,000), the investor will now own 100 shares of a $50 stock for the same total of $5,000 ($50 x 100 = $5,000).

Bite-size burritos

Chipotle announced this week that its board approved a 50-for-1 stock split. This means each shareholder will receive 49 additional shares for every share held. This is the company's first stock split in its 30-year history and the largest ever in the S&P 500. Although it may alleviate some of the challenges above, other motivations could be at play.

Stock splits can impact the marketability of a company’s stock in several ways. First, lowering the share price could increase demand from individual investors who have wanted to own Chipotle but couldn't afford to pay almost $3,000 for a single share. It may also attract investors who could have owned a handful of Chipotle shares but were put off by its high price. Now, they can own 50 times as many shares.

Second, stock splits are usually announced after a run-up in price or some other good news about a company's prospects. Chipotle’s stock is up more than 80% from a year ago, and investors tend to favor stocks with positive momentum. This interest, along with the media hype that follows, can add even more demand.

The third is index inclusion. For example, the Dow Jones Industrial Average (Dow) is a closely followed index of 30 price-weighted stocks, with higher-priced stocks carrying larger weights. Thanks to the media’s infatuation with the Dow, there is an incentive to get in and stay in the index. It's hard to say that Chipotle is positioning itself to be included, but it wouldn’t be the first time a company split its stock to gain favor with price-weighted indexes.

To be clear, there is nothing mischievous happening. Chipotle locations are slammed daily around lunchtime, and management continues to increase profits for shareholders. Hence, it’s not surprising they have had equal success selling their stock to investors. In fact, all large publicly traded companies have dedicated teams whose sole purpose is to market their stock to prospective investors and answer questions from existing shareholders.

Simply put, Chipotle is splitting its stock for the same reason any other company splits its stock – to sell more of it.

The bottom line

Advances in trading, the elimination of transaction fees, and the rise of passive funds (investors buying more index funds and fewer individual stocks) have made stock splits less common. Splitting a stock can cost as much as $800,000, so it’s also become cost-prohibitive2.

However, Chipotle’s stock popped nicely after they announced the split, and so did Amazon and Google weeks ago when they announced their stock split back in 2022. The herd mentality that drives corporate America may inspire others to follow suit.

Currently, over 58% of companies in the S&P 500 are trading above $100/share1. Historically, this was the line in the sand where management considered a split. Some high-profile stocks like AutoZone continue to trade above $3,000/share1. Meaning, there appears to be a healthy pipeline of companies that could be next.

The bottom line is that a stock split does not increase revenues, profits, cash flow, or competitive positioning in an industry. All it really can do is impact the demand, but that’s ok. Trends that expand the shareholder base, lower transaction costs, and simplify diversification for individual investors are a win for all.


 

 

Sources

1 yCharts, As of 3/20/2024

2 https://www.wsj.com/articles/stock-splits-pay-offon-the-rare-occasions-they-occur-11596274200


Disclosures

This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.