By Mark Hulbert, MarketWatch
ANNANDALE, Va. (MarketWatch) -- The late Fischer Black, the famous market theoretician and co-creator of the widely used Black-Scholes option pricing model, reportedly once said that the world looks a lot different from the bank of the Hudson than it does from the bank of the Charles.
He was referring to how his attitudes changed once he began working on Wall Street (for Goldman Sachs /quotes/comstock/13*!gs/quotes/nls/gs (GS 174.00, +0.92, +0.53%) , near the Hudson River) as opposed to in the Ivory Tower (MIT and Harvard, near Boston's Charles River).
Black's comment came to mind as I reviewed the evolution of thinking over the years toward companies that split their stocks. When I began monitoring newsletter performance in the late 1970s, academia had nothing but scorn for investors who believed that stock splits had any significance other than as a mere bookkeeping transaction. This didn't stop investors, however, who continued to bid up the stock prices of companies announcing a split.
A recent example of this phenomenon came Friday afternoon, when Progressive Corp. /quotes/comstock/13*!pgr/quotes/nls/pgr (PGR 20.13, +0.08, +0.40%) announced that it would split its shares four-for-one in May. The company quickly jumped several dollars per share on the news.
This stark polarization of opinion has softened in recent years, as evidence has piled up that the academic scorn was unjustified. It turns out that the average stock that undergoes a split tends to outperform the market for several years after the split is announced.
Consider the performance of an investment newsletter whose model portfolio only includes stocks that have announced a stock split. The newsletter is called, perhaps not surprisingly, 2 for 1, and it is edited by Neil Macneale.
Over the six and one-half years that the Hulbert Financial Digest has tracked this service, its model portfolio has produced a 12.8% annualized return, far outstripping the 1.3% annualized return over the same period of the Dow Jones Wilshire 5000 index . Even better, the performance of Macneale's letter has been remarkably consistent, beating the overall stock market in each of the calendar years that the HFD has tracked it.
Macneale's approach is not flashy, and he makes no attempt to time the market as a whole. Instead, each month he adds a stock to his model portfolio of a company that has recently announced a stock split. He invariably holds that stock in his model portfolio for 30 months, and then sells it.
As a result, his model portfolio at any given time holds 30 positions with an average holding period of 15 months. An investor wishing to follow this newsletter's portfolio could do so in less than five minutes a month.
The only judgments that Macneale must make come in deciding which stock to add each month out of the several that will have recently announced a stock split.
In his latest issue, for example, out of 20 companies having recently announced a stock split, Macneale chose to add Chubb Corp. /quotes/comstock/13*!cb/quotes/nls/cb (CB 59.81, -0.27, -0.45%) to his letter's model portfolio. Chubb split its stock two-for-one on April 19.
This choice reflects a proprietary valuation model that Macneale uses to rank those stocks that have announced splits. Naturally, Macneale doesn't divulge it.
But in an interview Monday afternoon, he did say that the model focuses on 11 separate factors, including market cap (the model favors smaller-cap stocks over larger ones) and valuation (the model favors stocks closer to the value end of the growth-vs.-value spectrum). Chubb, for example, sports a high yield (4.0%) and a low price/earnings ratio (11.1).
The tilt of Macneale's model toward smaller value-oriented stocks helps to explain some of the newsletter's impressive performance, since these investment styles that the model favors have been outperformers in recent years. But that tilt doesn't explain all of it. The newsletter also handily outperforms a custom index of all stocks with more or less the same market cap as Macneale's portfolio average and that fall on the same place on growth-vs.-value spectrum.
Why do stocks that split their shares outperform the market more often than not? Prof. Dave Ikenberry of the University of Illinois at Urbana-Champaign has extensively studied companies that split their stocks. He believes the answer traces to a "sweet spot" in which the typical company likes to have its stock trade. Though that sweet spot is not precisely defined, companies will not split their shares, even if the prices of those shares have risen sharply, if management believes there is a significant probability that their prices will fall back into that range by themselves.
In effect, therefore, stock splits are a signal from management that they have confidence in the continued appreciation of their companies' shares.
This rationale is crucial, since it shows that it is not the stock split itself that is bullish but what it signals in the minds of corporate management. The stock split of an index fund would not be bullish, for example, since the index is passively managed and has no management. In such a case, a stock split signals nothing.
It is especially important this week to keep this rationale in mind, as Rydex announced that it would be splitting four-for-one its exchange traded fund that is based on the equally-weighted S&P 500 index /quotes/comstock/13*!rsp/quotes/nls/rsp (RSP 47.81, +0.25, +0.53%) . You might be inclined to believe this split to be bullish for the market as a whole, but that conclusion would be unwarranted.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
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