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Investing in Stock Splits Can Pay Off Big

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Date: September 1, 2013      Publication: Bottom Line Personal      Source: Neil Macneale III      Print:

When a company’s stock “splits,” it’s not supposed to have much effect on investors. But Neil Macneale has used stock splits as the core of a successful investment strategy.

Macneale has capitalized on a powerful side effect of stock splits. Stocks that split two-for-one tend to beat the broad market by more than three percentage points annually, on average, for the two to three years after the announcement of the split.

Every year, dozens of companies split their stocks—multiplying the number of shares that each shareholder owns by two or three or whatever number the company decides. At the same time, the price of each share drops by an amount that prevents the split from increasing the overall value of each shareholder’s stake. As a result, the shares look less pricey to new investors, making them more likely to invest.

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Example: In May, Colgate-Palmolive’s stock was selling for about $124 per share. The company initiated a two-for-one split, meaning that the number of shares held by each shareholder doubled, with the value of each share adjusted to about $62.

Over the past 17 years, Macneale, who built a model portfolio and a newsletter around this phenomenon and initially invested $50,000 of his own retirement money, has achieved impressive results. His annualized returns of 10.8% outperformed the Standard & Poor’s 500 stock index by an average of nearly 3.5 percentage points a year. His portfolio also has beaten the index in 13 of those years. And his IRA has appreciated nearly sixfold to $277,651, earning him $151,910 more than the $125,741 that an equivalent investment in the S&P 500 would total.

Bottom Line/Personal spoke with Macneale to find out why this strategy seems to work and how our readers can use it…

THE MOMENTUM EFFECT

While a stock split itself doesn’t add any value, it often occurs after the stock has climbed in response to strong earnings growth. And a split is the most reliable sign I know that management has great confidence that the business will continue to flourish and that the share price will keep rising. At the same time, a split gives a stock a near-term boost because investors assume a much cheaper stock price will attract more buyers, so they pile in and push up the stock’s price.

To take advantage of this momentum, I maintain a 30-stock portfolio, and around the middle of each month, I purchase one new stock of a company that has announced a split within the past three to seven weeks, regardless of when the actual split takes place. At the same time, I sell off my oldest position.

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This ensures that each stock remains in the portfolio for 30 months, the sweet spot for performance according to stock-split studies.

Example: In April, I sold my oldest holding, the midcap stock ResMed, a maker of medical devices that had a 43.6% gain over two-and-a-half years. I replaced it with the regional bank Home BancShares (HOMB), which had recently announced a split.

This disciplined methodology—12 buys and 12 sells a year through a discount broker—keeps my trading decisions and costs predictable and affordable, only about $240 a year.

Some rules that I follow…

I use cash from the sale of the old stock to purchase the new one. My purchase amount always is equal to 3.33% (or 1/30th) of the total current value of the portfolio. If selling the old stock brings in more cash than I need to buy the new stock, I will use this excess cash to buy additional shares in the holding I own that has underperformed the most since I bought it—this represents good value. If I lack cash for the new buy, I generate more cash by selling a portion of my best-performing position.

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In a month when more than one company has announced a new stock split, I select the best bargain by using common valuation measurements such as the lowest price-to-earnings ratio and price-to-book ratio, compared with the company’s long-term averages for those ratios. (You can research these figures at Morningstar.com.)

If more than 20% of my portfolio is weighted in one industry—which currently is the case with energy stocks —I maintain diversification by avoiding additional purchases in that industry until the oldest stock is sold.

My strategy is best-suited for aggressive long-term investors in tax-protected accounts. Reason: It can be more volatile than the overall market. For instance, in 2008, my portfolio dropped 43%, versus a 37% drop for the S&P 500, although my portfolio bounced back 47% the next year, versus 26% for the S&P 500.

My five most recent buys, all involving two-for-one splits…

Colgate-Palmolive (CL) is one of the world’s largest consumer products companies. Its detergents, deodorants, shampoos and toothpastes are sold in more than 200 countries. As noted, its stock split in May. Recent share price: $60.25.

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Holly Energy Partners (HEP) is a master limited partnership with more than 2,600 miles of oil pipeline in the Southwest and western US. Its stock split in January. Recent share price: $39.50.

Home BancShares (HOMB) is a community bank operating mainly in Florida and Arkansas. Its stock split in May. Recent share price: $27.49.

ProAssurance Corp. (PRA) is a property and casualty insurer specializing in professional liability insurance for doctors. Its stock split in December. Recent share price: $54.14.

Telus (TU) is one of Canada’s leading telecommunications companies, with more than 7 million wireless subscribers. Its stock split in April. Recent share price: $30.57.

I maintain a list of announced stock splits on my Web site, 2-for-1.com (click “Splits” near the top of the page).

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Source: Neil Macneale III, editor and publisher of the investment-advisory newsletter 2 for 1, which focuses solely on stock splits, San Jose, California. Over the past decade, according to The Hulbert Financial Digest, his model portfolio has produced a 13% annualized return, outpacing the 7.3% gain of the S&P 500 including dividends. 2-for-1.com