Stock Splits: What’s New is Old Again
A curious phenomenon has overtaken the market in recent weeks…stock splits are hot again! In case you’ve been on a desert island or (horrors) a cruise ship in August, we shall fill you in.
Apple kicked off the fun by announcing a 4-for-1 split. This means that shareholders received 4 shares of stock for every 1 share they previously owned. If you had 100 shares before, now it’s 400. The price of the stock should naturally become ¼ of its previous value, so that the value of the company remains intact. It was $385 prior to the announcement (on July 30), so it should be $96 after the split is commenced, ceteris paribus. A month has passed since the announcement, and obviously the split is not the only thing affecting Apple, but the stock’s move to $134 (40% gain in 1 month) dwarfs the S&P 500’s return of +7% in August. Don’t forget, Apple was already the largest company in the world by market cap before the announcement, and was arguably already overpriced.
Tesla, meanwhile, one-upped Apple with a 5-for-1 split. Its stock was $1,418 prior to the announcement, so it should be $283 now. No, it’s $488, a gain of 72%. Since August 10. Tesla’s market cap is now $456 billion, which ranks as 7th largest in the U.S. Not bad for a company that still isn’t financially self-sustainable.
For those of us with long memories, stock splits were extremely common in the 1990s, but fell out of favor when the tech boom/bubble became a bust. There was great euphoria every time a company announced a split. Even though everyone knows a stock split doesn’t change the fundamental value of a company, there was a mystic belief that a management team was “signaling” that greater things are coming in the near future. Plus, a nebulous boost could come from more investors being able to buy the stock. That sounds realistic when you consider Tesla hit $2,000 per share, and new investors starting out might find $2,000 hard to come by. But please consider these facts. First, there are already ways to buy “slices” of stock, like you can buy 1/10 of a share. Second, just how much is a stock worth $456 billion going to be pushed up by investors who don’t have $2,000 to invest? Finally, trading commissions are very low these days, and are typically a flat fee per trade anyway, regardless of share price or number of shares. This was not the case back in the 1990s, when it was still hard to buy an “odd lot” of shares, or less than 100.
Why did stock splits fall out of favor? The most obvious reason is just that…they fell out of favor. A high stock price became en vogue, a sign of a successful company. The following chart shows the average stock price of companies in the S&P 500. We remember back as recently as 4 years ago, we were routinely welcoming new members of our core stocks to the $100 Club. Now most stocks seem to be over $100.
So did Apple’s and Tesla’s stock splits actually “work?” Did the splits actually contribute to the outperformance enjoyed by both stocks? That’s a very good question. If the answer is yes, and we believe it is a resounding yes, then every company right now should be figuring out how quickly they can split their stock. We are waiting on the edges of our chairs for the next company to announce.
What does this mean for the market as a whole? We believe the mania for hot stocks is quickly inflating into a bubble, and the stock split phenomenon is very strong evidence. Apple is now worth $2.3 trillion, and is now worth more than all 2,000 stocks in the Russell 2000 (the small-cap index) combined. It is worth more than the sum of all 100 stocks in the FTSE 100, the 100 largest stocks in the U.K. It is worth more than all German stocks combined. At its current price, Apple trades at 42 times this fiscal year’s earnings. When we started buying the stock in 2016, it traded at 11 times earnings. While its earnings grew surprisingly well in the 2nd quarter, and are poised to grow nicely next year, they have not grown much in the last 5 years. In fact, EBITDA (earnings before interest, taxes, depreciation and amortization…one of the cleaner measures of earnings) is still lower now than in fiscal 2015. EPS (earnings per share) have grown largely thanks to the tax cut and share buybacks (funded in part by $70 billion of new net debt since 2015). Future growth is great…as long as it comes to fruition. This makes us think of the old “hockey stick” method of forecasting future earnings, used universally by sell-side analysts:
Never mind that flat period in the past…growth is preordained for the future! To be sure, Apple has done a lot of good things in the last 5 years, much of which has served to lock up its loyal user base, and entrench itself further with younger users. Services and accessories are more dependable sources of profits and growth, and are the two factors which attracted us to the stock in the first place.
Tesla is certainly poised to continue to sell more cars, which is good, because its market share is 2% currently. Despite that, the stock is worth more than every other automaker in the world…combined. Furthermore, Tesla is still not selling enough cars to be self-sustaining. It frequently borrows more money, at a rating of “B” (the 5th highest junk rating), and just announced today it is selling $5 billion of new shares to raise more cash.
Here’s some more fun facts. While the S&P 500 has gained 8% in 2020, the Equal-Weight S&P 500 is -4%! The latter index has the same 500 stocks, but they all have the same 0.2% weighting in the index. So, the average stock in the index is down 4% in 2020. This gives you an idea of how much the market has been driven up by a few very large stocks, and that investors are crowding into them, at the expense of all other stocks. In fact, the correlation between the S&P and the S&P Equal Weight has only been lower once ever, and that was in 1999. The 5 largest now comprise 26% of the index. The highest weighting for the top 5 at the height of the tech bubble in 1999? Only 18%. While this has been very much a large-cap stock market in 2020, the “other 95” of the largest 100 stocks in the S&P are actually down this year. Small caps are down 6%. The Dow is also down this year, despite Apple being the largest weighting within the index.
Right now, the commonly-held narrative is that this era is made for tech, and it will never end. We agree that some adoption rates—e-commerce, collaboration software, to name a couple—have been massively accelerated by the pandemic. Unlike the uptake in past cycles of tech adoption, though, this one was forced on people who couldn’t get together, or travel, or go into stores or restaurants. If the reason for the uptake goes away, how will that affect the adoption rate? That is the trillion dollar question. Reasonable minds can disagree on this, and they do. We are fairly confident that we will see adoption rates subside, even if the secular trends (i.e. e-commerce growing at the expense of brick-and-mortar) remain intact. How will investors react when growth rates slow, then turn negative? At these valuations, it would be hard to be bullish even through rose-colored glasses.
We still like the stocks we hold for the long-term, but when stock charts go parabolic, as they have for a handful of stocks, it is not sustainable. There will be an ugly correction (or crash) at some point in the tech sector. It begs the question of whether it would be timely to sell now. Believe me, this is a question we grapple with every single day. We have occasionally trimmed holdings, and it’s painful to watch the stock you trim go straight up. Someday it will have been the right thing to do; we just don’t know when someday will be.