Tricks Of The Trade

Understanding the ins and outs of stocks isn't easy. Here are a few of their magic tricks.
Magazine Contributor
8 min read

This story appears in the March 1998 issue of Entrepreneur. Subscribe »

They split, they merge, they are issued shares and bought back when you least expect it . . . They do everything but wriggle on their bellies like a reptile. They make up part of the greatest show on earth. What we're talking about, of course, are stocks. Who has never wondered if a stock will split and whether it's better to buy shares before or after the split? Or whether a stock buyback is as wonderful as it sounds? Ringling Bros. and Barnum & Bailey may have a few tricks under the big top, but nothing can compare to the ups and downs of the "common" stock. Following are some tricks of the trade.

Lorayne Fiorillo is a financial advisor at Prudential Securities. For a list of stocks that are splitting, send her a self-addressed, stamped envelope in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614. Past performance is no guarantee of future returns.

In The Center Ring

Hurry, hurry, hurry! Step right up and get your dividends here! After a corporation has earned a profit, it must decide whether it will pay a dividend. Utilities usually distribute a large portion of their earnings. Real estate investment trusts (REITs) distribute almost all their earnings, while growth companies like Microsoft pay no dividend at all. Whether they're paid in cash or shares of stock, dividends are important to investors and to the performance of their portfolios. Most companies that pay cash dividends do so on a quarterly basis, although some pay monthly or semi-annually. Dividend payments often increase as earnings increase, making some companies' stocks more attractive to investors who seek income as opposed to capital gains.

Who gets the dividend? Holders of a stock on the date of record receive the dividend. The stock trades ex-dividend (without a dividend) two days prior to the date of record, and purchasers at this point do not receive it. In other words, if you purchase two days before the record date, that trade will settle one day after the record date and you will not be entitled to the dividend. Stocks that are trading ex-dividend show an "x" next to the volume of transactions in financial newspapers.

Though some investors think otherwise, buying or selling a stock on the ex-dividend day does not necessarily result in a windfall profit or immediate loss. If a stock is selling for $50 per share and declares a 50-cent dividend, the price of the shares is reduced by the amount of the dividend, making the price per share $49.50 on the ex-dividend date. If purchased prior to the ex-date, an investor would pay $50 and receive the dividend. If purchased after the ex-date, the price would be less the dividend payment. Whether you should buy a dividend-paying stock depends on whether you want to receive a dividend or pay a lower price for your shares. If you're buying shares in a taxable account and do so just prior to the ex-date, you'll receive the dividend and have to pay tax on it--like paying tax on your own money. For some investors, it pays to buy after the ex-date. Consult your tax advisor to determine what's best for you.

If you'll be receiving a dividend, it may be a long time coming. The day the dividend is paid, known as the distribution date, may be several weeks after the date of record. Most companies make payments on a consistent basis, though, so their investors can count on a date the dividends will arrive.

Instead of paying investors in cash, some companies choose to distribute profits in shares of stock. Stock dividends don't change the value of an investor's holdings, although some investors incorrectly believe that a stock dividend increases the assets of the underlying firm.

Here's how it works: Company XYZ declares a 10 percent stock dividend. An investor who holds 100 shares at a price of $20 would then own 110 shares with a price of $18.18. The stock price falls because the number of shares has increased. Stock dividends increase a company's ability to grow because the company still has the cash to invest elsewhere.

Doing The Splits

There's almost nothing investors love more than to hear that their stock is splitting. Having more shares makes you feel like you have more money. But like a peek into the fun house mirror, all is not as it appears. Stock splits are actually a form of the lowly dividend. Here's how they work: Say you own 100 shares of XYZ corporation whose price per share is currently $50. If it splits two for one, you suddenly have 200 shares at a price of $25 per share. No matter how you cut it, the value of your investment is the same: $5,000. Perhaps it's the loaves and fishes concept that makes stock splits so attractive--where there once was one, now there are more.

On the other hand, stock splits can perform several useful functions, often increasing a stock's liquidity and dropping the share price to a level where small investors can participate. Many small investors who can't afford stocks trading at $100-plus prices wait for big-ticket stocks to split. Though splits are normally just a mathematical affair, pent-up demand could cause post-split prices to climb higher.

Bull markets often mean more splits. Since October 1990, nearly half the companies listed in the Standard & Poor's (S&P) 500 index have split their stock. In 1996, 166 New York Stock Exchange (NYSE)-listed companies split their shares, up 26 percent from the previous year. The record for stock splits was set in 1983, when 225 NYSE-listed companies split their stocks.

Splits have also seen positive market reaction because they often signal that a company's management is positive about its future. While past performance is no guarantee of future results, stock splits are often used as a measure of market performance. Prudential Securities research found that nine of the 14 companies in the S&P 100 index that split their stocks in 1996 have outperformed the index, which rose more than 22 percent, by an average of 8.38 percent.

Should you buy before or after the split? Often, the price of shares will dip right after a split as investors sell shares to diversify. In the long term, stock splits are rewards given to longtime shareholders, so if you own a stock that splits, you should hang on to it.

There is also more than one type of split. The reverse split is used by companies whose share price is very low. The number of shares outstanding is decreased and the price of shares increased. This is done to attract investors who wouldn't think of buying a stock selling at $2 per share but who might buy shares selling at $20 each.

To find out which stocks are splitting, check Barron's financial newspaper or consult your financial advisor.

Balancing Act

To an unknowing observer, October 27, 1997, seemed like any other day on Wall Street. But after a steep drop in foreign markets, the U.S. stock market tumbled, dropping several hundred points before circuit breakers shut the action down. The next day, traders and investors awaited the opening with the trepidation of acrobats on a high wire in a hurricane. Stocks opened down but bounced back after IBM announced a stock buyback, the announcement acting like a safety net for the plummeting market. In all, 120 companies announced plans to buy back shares of their stocks, and some analysts viewed these announcements as part of the sentiment that stopped the market's free fall. Stock buybacks are seen by many investors as a sign that a company's stock is undervalued. Often, the share price rises after the announcement of a buyback; after all, if shares are good enough for a company to buy back, they should be a pretty good buy anyway, right?

Not so fast. First, while many companies announce share buybacks, businesses are under no obligation to make good on their claims. Some companies do repurchase shares, buying them only to reissue to employees in the form of stock options. Still others borrow heavily to buy shares, thus replacing equity with debt, leaving investors with a more leveraged company, a weaker balance sheet and more potential difficulty in an economic downturn.

Share buybacks are enticing, but before you invest, make sure the company's earnings are still growing, not faltering. The repurchase of shares could limit a company's ability to invest in research and development or buy another company. So look before you leap.

The properties of stocks may not seem so magical now, but we hope you'll see this is one act that may have something for everyone. Come one, come all.

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