Stock Splits Enriching Trading Firms More Than Investors

WASHINGTON -- Many small investors still applaud when they hear of a stock split, assuming the company must be healthy, or that the more shares they own, the faster their investments will grow. Wall Street pros have long known that splits -- usually issued when a stock hits a price deemed too steep for ordinary investors -- do nothing to change the overall value of the shares. Now comes new research that indicates splits, in fact, may be harmful to consumers while lucrative for trading firms.

"I thought that people weren't taken in by stock splits, but I guess not," said Paul Schultz, a finance professor at the University of Notre Dame, who conducted the study and whose previous work triggered a Nasdaq price-fixing scandal.

His latest research indicates that when a stock splits, small investors snap it up at the urging of brokers and trading firms, which are able to earn more through higher trading profits and per-share fees.

Thus, stock splits may represent another example of how small investors find themselves at a disadvantage when playing against the bigs on Wall Street. They also illustrate a little-known conflict of interest: The same investment banking firms that advise companies on whether to split their stocks are also in a position to earn more if splits take place.

With stock prices up over the last decade, the number of splits began to accelerate in the early 1990s and have remained at historically high levels. Stock splits on the three major exchanges have averaged about 970 annually in the last five years, ranging from 869 in 1995 to 1107 in 1998, according to the Center for Research in Securities Prices.

The Split Decision With stock prices up in the last decade, stock splits have been on the rise. Activity since 1995:

Among the three major trading centers, stock splits vary by size of company.
Trading center	Portion of splits by biggest firms*
New York Stock Exchange	84 percent
Nasdaq	31 percent
American Stock Exchange	13 percent
**1Q only *Firms in upper 30 percent of market capitalization Source: Center for Research in Securities Prices

On the surface, a split doesn't have much financial sex appeal: A company cuts its stock price while boosting the number of shares. If, say, a company with 1 million shares outstanding at $100 split its stock 2 for 1, there would be 2 million shares outstanding at $50 apiece afterward. So economically, splits are a wash.

But that hasn't stopped the emergence of a cottage industry to advise consumers on how to play splits. These shops offer advice, analysis, predictions and even email or pager alerts of split announcements. As the online site StockSplits.com breathlessly declares, for example, "no other news event has the stock-moving power of a stock split." History shows that isn't quite true, but the huge promotional effort has made splits a siren that many investors find difficult to resist.

Typically, companies split their stocks to broaden ownership by making the price more attractive to small investors. They might also want to attract big investors like mutual funds, which often don't want to hold big positions in companies with small floats.

Schultz's study examined 235 splits among Nasdaq, New York Stock Exchange and American Stock Exchange companies during a 12-month period between 1993 and 1994. The study advances work done in the same vein by other researchers, and was published recently in the Journal of Finance.

Wall Street, though, rejects the report. Frank Fernandez, chief economist for the Securities Industry Association or SIA, the industry's leading trade group, said the research has only surface appeal and is outdated and off the mark.

Schultz said his research showed that some of the traditional explanations for splits seem to hold, in that small buyers jump into postsplit trading in a big way. But "the twist here is they're buying despite the fact it's more expensive to do so."

How so? Several ways. Firms that are so-called market makers in Nasdaq stocks -- that is, they serve as intermediaries, buying from investors looking to sell, and selling to those wanting to buy -- can profit through a higher "spread." That's the difference between what the dealers pay to buy and what they get when they sell. A spread might be, say, an eighth per share, or 12.5 cents. The spread may shrink, post-split, but it rarely falls by the same proportion as the share price. And sometimes the spread doesn't narrow at all.

That means the dealers' profit margin goes up, as the spread becomes a higher percentage of the price of each share: An eighth on $25 is bigger than an eighth on $50. Specifically, Schultz found the margin ballooned by as much as 58% following splits, depending on the size of the transaction involved.

Meanwhile, the lower post-split price means that the same dollar amount buys more shares. So, with more shares in circulation, anything that racks up fees on a per-share basis stands to benefit. For instance, brokers who handle exchange-listed stocks, like Big Board issues, can benefit through orders routed to affiliated specialist firms that handle the flow.

Firms also can profit from splits because they can generate additional "payment for order flow" fees, a common but controversial practice that critics say harms investors. Under payment for order flow, trading firms pay brokers to steer their customers' orders to them for execution. So, again, the more shares that change hands, the more payment for order flow a firm receives.

All this adds up to a strong incentive for brokers and trading firms to push a newly split stock on their customers, Schultz and others believe.

"Nobody does anything in the equity market out of the purely charitable instinct," said James J. Angel, an associate professor of finance at Georgetown University, who has also done research in the area. "There is more in it for the financial community to push the stock."

Indeed, it's not hard to find examples of firms touting a stock close on the heels of a split. When Pinnacle Systems, (PCLE Quote) a California-based digital video company, split its stock in March, analysts at two firms were out with buy recommendations on the day after the newly split shares began trading. And when Proxicom, (PXCM Quote) a Virginia Internet services company, split its stock in February, four firms were highlighting the stock within a day. Some of these firms were market makers for the companies, or had previously underwritten stock offerings for them.

In fact, recommendations made in the wake of splits are the next place Schultz thinks research should go.

The SIA's Fernandez disputes Schultz's conclusions. He says it's the lower post-split price, not promotion by the trading community, which attracts investors. And while having more shares in circulation can boost per-share compensation, other forces in the industry are eating that away, he said.

Spreads have narrowed following market reforms, and brokers and trading firms today offer lower commissions than ever, he said, such as heavily discounted online trading fees. Furthermore, he says that by now, the data from 1993-94 make the Schultz study "a very interesting historical note not of much relevance today."

Schultz, whose work with a colleague in 1994 brought about a major Securities and Exchange Commission probe into apparent collusion among Nasdaq market makers, doesn't buy that. The basic forces at work haven't changed, he says.

On the other hand, even if the consumer-friendly changes in the brokerage industry over the past several years have cut fees, as Fernandez points out, it's hard to see the harm: Last year, riding heavy trading volume, the industry racked up a record $16.3 billion in pretax earnings, blasting past the previous record of $12.2 billion in 1997.

Another concern regarding splits arises from the investment banking functions of big Wall Street firms, which dish out advice to companies on whether to make the split decision. A New York Stock Exchange study, for instance, once found that 60% of companies splitting their stocks got outside advice on whether to go for it.

"The CFO or the CEO may come up with the idea, but more often than not, their investment banking firm is going to go to them [and] say, 'Let us do an evaluation of whether it makes sense for you to split your stock,' " said Charles Kaplan, president of Equity Analytics Ltd., a New York financial consulting firm that, among other things, examines stock splits.

Kaplan and others insist there's simply too much riding on splits for anything other than sound advice to carry the day. Still, he said, "if they can do it, they'll do it -- it's fees for them. They'll go out and look for the client."