In case you’ve been living under a rock and missed the hundreds of articles, discussions, and analyses of Apple‘s stock split yesterday, shareholders such as myself now have seven times as many AAPL shares in our accounts. Since I get the impression that many AAPL shareholders are inexperienced in trading stocks, I figured I would shed some light on what exactly a stock split is and why Apple shareholders should be happy about it. In my book Beating Wall Street with Common Sense, I address the topic of stock splits in great detail:

Sometimes, the stock of a great company like Walmart will climb so high that its price is hard to afford for many average investors. Rather than allowing high prices to discourage buyers, the company will issue a stock split. When a company issues a stock split, they are literally splitting the shares into pieces. For example, in 1999, Walmart issued a 2:1 stock split. If you had owned 100 shares at $90 per share before the split, after the split you would have owned 200 shares at $45 per share. Since the pizza analogy has been beaten to death, let’s use an apple pie this time: more slices does not mean more pie. The market cap of Walmart did not change. Notice that there is no inherent value creation or destruction that results from the split itself: before the split you owned $900 worth of stock, and after the split it is still $900 worth of stock. However, stock splits are generally seen as a good thing for companies for two main reasons. First, the stock split lowers the cost of shares and psychologically makes the shares seem more appealing to investors. Secondly, a company usually only issues a stock split if its share price has risen significantly in the past. Therefore, a company issuing a stock split has likely performed well in the recent past. Walmart, for example, issued nine 2:1 stock splits between 1971 and 1999! The “2:1” ratio represents the number of shares each old share will be split into, and can be any number the company chooses, such as 10:1 or 15:1. Each time, the number of shares will be multiplied by the first number in the ratio, and the share price will be divided by the first number specified in the ratio.

So there you have it. Despite the fact that the split itself does not directly create value for shareholders, it’s typically a good thing. From the Wall Street Journal:

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. 

But before you Apple shareholders get too excited, I must point out two caveats: 1. These stocks tend to outperform the market. Outperforming the market could mean that the stock gains 10% when the market gains 5%. Or it could mean the stock loses 5% when the market loses 10%. And if you think the market will keep rising forever without any major corrections, read this: http://tradingcommonsense.com/?p=337. Caveat number two can be seen in a chart of AAPL over the months leading up to the stock split:

For the sake of a smooth transition, the prices on this chart prior to the split have been adjusted (by dividing by seven). As you can see, the stock had risen over 20% in the past three months before the split. This makes sense because lots of people want to buy before the split happens because they expect that the split will lead to a rise in share price. This anticipatory buying drives the price up before the split actually takes place. Notice that the Wall Street Journal specifically referenced the date of the “announcement” of the split rather than the date that the split actually takes place. As an Apple shareholder, I am hoping that the lower share price and the upcoming line of Apple product launches will continue to drive the price higher, but I’m not going to freak out if the next couple of weeks aren’t as rosy as everyone seems to assume they will be. I wouldn’t be surprised to see some naive traders with high expectations lose patience with Apple and sell in the next couple of weeks. After those short-term traders are flushed out, the stock should be free to (hopefully) follow the upward trend that most stocks follow in the years following a stock split.

While I’m on the topic of stock splits, I’ll take this opportunity to address the stock split’s evil twin: the reverse stock split. From Beating Wall Street with Common Sense:

A reverse stock split is a stock split in reverse, and is usually done for many of the opposite reasons. For example, since Citigroup had diluted its shares so much during the financial crisis, its share price had dropped drastically. In May 2011, Citigroup decided that it would be best for the company’s image to have a higher share price, so it issued a 10:1 reverse stock split. The result was that every 10 shares of Citigroup instantly merged to only one share, and its share price jumped from $4 to $40. Again, no value was inherently created or destroyed, but the company issued the reverse split because of poor past stock performance. Whereas Walmart shares have climbed each time after their splits, many companies’ share prices, Citigroup included, drop after a reverse split. Nearly two years later, shares of C have just recently climbed back above $40 while the market as a whole has seen major gains during that time.

Unfortunately for Dynavax shareholders such as myself, a reverse split seems to be in the works for DVAX in the near future. I still believe that the long-term future of DVAX hinges on the success or failure of Heplisav, but this reverse split is likely bad news for the shorter term.

Does the motion of the stock market seem completely random sometimes? Or maybe you just want to look sophisticated in front of your coworkers when they ask you what you are reading on your Kindle, and you’d prefer to tell them “Oh, I’m just reading a book about stock market analysis,” rather than the usual “Oh, I’m just looking at pics of my ex-girlfriend on Facebook.” For these reasons and more, check out my book, Beating Wall Street with Common Sense. I don’t have a degree in finance; I have a degree in neuroscience. You don’t have to predict what stocks will do if you can predict what traders will do and be one step ahead of them. I made a 400% return in the stock market over five years using only basic principles of psychology and common sense. Beating Wall Street with Common Sense is now available on Amazon, and tradingcommonsense.com is always available on your local internet!