Sivy on Stocks

Frequently asked questions I
Can stock splits and buybacks increase total returns? What should I do with a spinoff? More...
August 18, 2004: 10:12 AM EDT

NEW YORK (CNN/Money) - Q: Does being included in an index like the Dow or the S&P 500 increase a stock's returns?

A: Just being in an index doesn't have much long-term effect. But stocks typically receive a quick boost when they're added to a major index and go down a little when they're kicked out.

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That's because many mutual fund managers aim to match or exceed the performance of the Dow or the S&P 500, leading them to hold many of the same stocks. As a result, money managers frequently load up on new additions and dump stocks that are removed.

Q: Are stock splits good for shareholders?

A: Studies confirm that splits are good for share prices. According to one study, stocks that split two-for-one outperform the market over the following year by an average of four percentage points. That may not seem logical, since a split has no fundamental impact on value: You simply get more shares that are worth proportionately less.

But there are explanations. By reducing the share price, splits make it easier for small investors to buy 100-share round lots, boosting demand for the stock.

In addition, no company wants to split its stock and then watch it decline. So a company's top managers aren't likely to authorize a split unless they are truly optimistic about the future. Of course, management confidence means more for blue chips than for start-ups, which may well disappoint even their own insiders.

Q: How beneficial are stock buybacks?

A: Companies that regularly buy back their own shares can outpace comparable stocks by as much as three or four percentage points a year, on average.

In simplest terms, buybacks ensure that earnings -- and earning increases -- are divided among a smaller number of shares. As long as the stock is cheap enough that the cost of the buyback is less than the benefit of shrinking the number of shares outstanding, earnings per share will rise.

As a result, buybacks are most effective when a company has at least 12 percent annual growth and a P/E below 20. Of course, those are the same characteristics that conservative growth investors look for (see "Investing for growth"ADD LINK ADD LINK). So you should first choose stocks based on fundamentals, and only count buybacks as a bonus.

Two cautions: Buybacks of high-priced stocks may not help much. And not all companies that announce buybacks actually follow through and repurchase shares.

Q: Should you hang on to a spinoff?

A: When a large corporation spins off some of its operations as an independent firm, the new stock may fall in the first month or so.

Reason: Many existing shareholders who receive a spinoff dump it. Index funds, for example, won't hold it if it's not in their index. And individual investors may sell because the company doesn't fit their investing style.

Following the initial dip, however, spinoffs often go on to be stellar performers. In fact, one study found that from their lows spinoffs outperform comparable stocks by as much as 20 percentage points over the next 18 months.

If you own a stock in a company that is going to grant you shares in a spinoff, it may be smart to wait at least a year before selling the new shares. On the other hand, if you aren't a shareholder and the spinoff is a stock you'd like to own, consider waiting until after the initial dip.  Top of page

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