Doing the Splits: Dividing Your Shares
Stock splits are a regular occurrence in the capital markets. This fall, Toyota Motor Corporation in Japan, Equitable Bank in Canada and Intuitive in the U.S. were the latest large and mid-sized companies to engage in this practice. Proving that the splits are not just reserved for big-board players, Saturn Oil (TSXV: SOIL), Jade Power Trust (TSXV: JPWR) and Canadian Overseas Petroleum (TSXV: COPL) also got into the act this fall.
This issue of IR focus looks at stock splits from all angles: why and how companies do them and what effect, if any, they have on shareholder value.
Why Companies Split Their Shares
A stock split is a transaction whereby a company splits each of its shares into equal parts. There are 5-for-1 splits (Toyota), 3-for-1 splits (Intuitive), 2-for-1 splits (Equitable) or pretty much any equation that makes sense to a Board of Directors and/or its shareholders.
Mathematically speaking, a stock split is a superficial or cosmetic change to a security’s price and shares outstanding. It does not increase earnings, provide higher dividends or have any impact on the market value of each investor's holdings, or the investor’s proportionate equity in a company. So why do companies bother?
Among the reasons most commonly provided by issuers are, first, that a lower post-split share price will make it easier for individual investors to buy stock, and second, that the split will help broaden a company's ownership base.
This appears to be the general rationale used by Toyota in September 2021 when it completed its first stock split in three decades. According to a Reuters report, Toyota leads Japanese corporations in market capitalization but was in 15th place in sheer number of stockholders. At the end of March 2021, Toyota had 430,000 shareholders. First place SoftBank had 850,000 and Nissan Motor had 560,000. The report said that retail investors made up less than 12% of all Toyota stockholders, “falling below the average of 17% among Japanese-listed companies.”
In the Reuters story, Kenji Abe, Chief Strategist at Daiwa Securities, said that for the 602 stocks that have split since 2006 on the Tokyo Exchange, the number of retail investors increased by roughly 10% in the year after the announcements, and by 20% after two years. It is evident from these data points that Toyota wanted to broaden its retail shareholder following. In addition, the split may have been part of a more general push to improve shareholder value, as it followed a 250 billion yen share buyback announced in May.
Similarly, Equitable in Canada noted in an analyst conference call that management had completed research on splits and the electronic trading patterns for its common stock. That research showed that Equitable tends to “experience higher trading volumes outside of the TSX including in dark pools, more odd-lot trading, wider bid-ask spreads, higher volatility within quarters, and possibly lower access for retail investors. Our understanding is that the lower stock price resulting from the split will encourage dealers to apply more capital to holding an inventory of shares and should shrink the bid-ask spread.”
Dollar volume and bid-ask spread are common proxies for liquidity. Like Toyota, Equitable noted that its split was part of an overall program of activities with the goal of closing what it considers a “material discount to a fair valuation” for the company, which is a leading digital bank.
It is also possible – though for obvious reasons not documented in public disclosures – that managers split shares when the share value rises beyond a target price range. Conversely, perhaps companies will not split their shares if they believe the price will decline below a targeted range.
How Do Markets React to Stock Splits?
Determining an answer to this question was the subject of periodic studies decades ago. In a paper published in 1969, University of Chicago researchers named Fama, Fisher, Jensen, and Roll documented how share prices behave around the time of stock splits. Although by presents standards their research would not hold up to scrutiny, in part because they used monthly trading data and were constrained by the technology of the day, it does offer some interesting and provocative insights. For instance, substantial excess returns are achieved by companies when they first announce the intention to seek a stock split and this may be because investors interpret such transactions as improving the likelihood of future dividend increases.
Further studies examined the theory that markets learn about a company’s fundamentals from stock splits. Research in 1989 by Harvard’s Paul Asquith and Krishna Palepu, along with MIT’s Paul Healy, hypothesized that companies are more likely to split their stock when they are confident that the firm’s past earnings growth is not temporary in nature, and that post-split earnings growth is likely to be more permanent. Theories like this postulate that splits themselves convey (positive) information, and the act of splitting is viewed by the capital markets as a sign that the companies involved are feeling good about themselves.
Another theory holds that it is increased liquidity that stocks achieve from splits that leads to higher shareholder returns rather than any sort of underlying feel good message coming from the announcement of a pending split.
Buffett on Stock Splits
Not everyone is a fan of stock splits. One high profile and vocal opponent is Warren Buffett. He has said that Berkshire Hathaway’s Class A shares will never be split because, he argues, high share prices attract like-minded investors who are focused on extended time horizons as opposed to short-term price movements. Buffett has never wavered on this point. On the other hand, even the Oracle of Omaha was not averse to the concept in 2010 when he used Berkshire’s Class B stock to finance the US$27 billion acquisition of Burlington Northern Santa Fe Corp. railroad. At his urging, Berkshire Hathaway shareholders approved a Class B share split on a 50-for-1 basis, reducing the per-share price by almost US$3,400 to roughly US$67. In the first 30 minutes after the split, those shares traded up by almost 5%. They are now worth approximately US$282 each and have not split since.
The Mechanics: Push-Out, Call-In or Stock Dividend
There are two methods of effecting a stock split: push-out or call-in, although the former is preferable according to the TSX Company Manual (section 620).
Under the push-out method, shareholders keep the security certificates they currently hold and, on a record date set by the company, are provided with additional security certificates by the listed issuer. Due bills, which are promissory notes, may also be used to ensure that the correct owner receives a stock's dividend when the stock trades near its ex-dividend date.
Under the call-in method, the listed issuer executes the stock split by issuing new (replacement) certificates to shareholders. In these cases, Letters of Transmittal are sent to securityholders requesting that they exchange their certificates at the offices of the issuer's transfer agent.
When the push-out method is used by TSX-listed companies, a Certificate of Amendment, or equivalent document such as a certified copy of a Directors’ Resolution – if no amendments to the articles of incorporation are required – must be issued at least five, and preferably not less than eight, trading days prior to the record date. The implication of this timing is that in cases where shareholder approval must be sought to split the shares, a meeting of shareholders must take place at least five days before the record date. Due to the cost of convening a single-purpose shareholder meeting, many companies opt to include a share split resolution during their annual meetings.
There is another method to effect a stock split without the need for a shareholder vote and that is the declaration of a ‘stock’ dividend rather than a cash dividend. In such cases, the dividend is paid in the form of equity or shares instead of cash and results in an increase in shares outstanding. Stock dividends can also be used as a method to distribute shares of standalone businesses to shareholders as part of a spin-off or so-called butterfly transaction.
Tax Implications for Shareholders
Generally, a stock split carried out through a special resolution that amends the articles of the issuer will be viewed by the Canada Revenue Agency as a non-event for income tax purposes. This is true of the push-out or call-in method.
Assuming that the stock split is achieved by passing a special resolution to amend the articles of the corporation, shareholders must recalculate the adjusted cost base (ACB) of the shares to reflect each split. This ACB is calculated by dividing the total cost of the shares (including expenses involved in their acquisition), by the total number of shares of that class owned. For example, if you owned 100 common shares of ACME Incorporated that cost $1,000 to purchase, the ACB of each common share would be $10 ($1,000 ÷ 100). If the common shares of ACME subsequently split 2-for-1, you would now own 200 common shares. The ACB of each common share must be recalculated and would now be $5 ($1,000 ÷ 200).
When there is a share disposition in future, the new ACB will be used to calculate a capital gain or loss by the shareholder.
Historically, however, many stock splits in Canada were implemented through a nominal stock dividend, which, as noted above, only requires a Directors’ resolution. For tax purposes, stock dividends result in a dividend equal to the investor’s share of the increase in the ‘paid-up’ capital of the corporation resulting from the payment of the dividend. In most cases, this amount is negligible and not reported on a T5 slip. If the increase in paid-up capital is large enough to be reported on a T5 slip and it is received from a Canadian corporation, the deemed dividend is grossed up and subject to the (favourable) dividend tax credit treatment. (Foreign stock dividends are not grossed up and are not subject to the dividend tax credit.)
Tax changes introduced in 2015 cast doubt on whether the stock dividend approach to achieving a stock split is still viable. Canada’s Department of Finance was approached to introduce amendments to make clear that a nominal stock dividend could be used to achieve a stock split in a tax-efficient manner. The Department has not introduced any such amendments to date. Accordingly, it is likely advisable to implement a stock split by way of a special resolution amending the articles of the issuer rather than by declaring a nominal stock dividend.
Share Consolidations
Companies can also consolidate their shares with prior approval by the stock exchange on which they are listed. This reduces the number of shares outstanding and increases the price per share. One reason for undertaking a consolidation, or reverse split, is that a company’s shares can be delisted if its stock price falls below the stock exchange’s minimum price threshold. A higher share price is also considered more respectable by some investors. Although most companies do not have to seek shareholder approval for a reverse split, they do have to meet several conditions. For TSX companies, the issuer’s transfer agent must provide written evidence that on a post-consolidation basis, there will be at least 500,000 freely tradable securities held by at least 150 holders, each holding a board lot or more.
Thoughts for IROs
Stock splits often come in waves and those waves can coincide with broader market movements. In the years following the 2007-2009 Great Recession, an average of 12 S&P 500 companies split their stocks annually, according to S&P Dow Jones Indices. In comparison, an average of 64 companies in the S&P 500 split their stocks each year in the 1990s and 102 did so in 1997 during the dot.com craze.
With healthy valuation levels for many stocks today, it is possible that more splits are coming. For IROs, it pays to know the mechanics of how splits work and the capital market’s perception of the strategy in case it arises in discussion in your boardroom. Closely tracking your share price versus peers, understanding where your shares are traded (e.g. how much in dark pools) and having an informed view of liquidity measures such as bid/ask spreads are table stakes for IROs and will help you in your quest to be a trusted advisor within your company when/if it becomes time to do the splits. And if that time comes, remember there will be work to be done to explain the reason for the split, organize a shareholder vote, issue news releases both before and after the event, and restate EPS and other share-based financial data. In order to ensure a smooth process in a share split scenario, the IRO’s attention must be undivided.
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