Why it can sometimes pay to invest in illiquid stocks

In nervy markets, lower liquidity can make more difference to shares in major companies than you’d expect

The news that Apple is to carry out a 4:1 stock split has sent the tech giant’s shares soaring again. Apple’s stock price is up by 20% since 30 July, when the split was announced, having already doubled over the past year.

Stock splits theoretically shouldn’t make any difference to the price of a share. Yet studies show that when companies split their stock, they tend to outperform over subsequent periods ranging from months to years. (The opposite is true for reverse splits, which is bad news for floundering voucher-deals firm Groupon: its recent 1:20 consolidation seems unlikely to check its steady march towards zero.)

The standard explanation for this is that splits improve liquidity: small investors can now join in the fun and push prices up further. This is doubtful beyond an initial frenzy (see below) and in any case Apple is already highly liquid. The more plausible argument is that firms tend to split when they are doing well, so a split is a consequence or a signal of a bullish outlook rather than a cause. If Apple keeps rising, this will probably be the reason, rather than higher liquidity.

Investing alongside the family

In any case, lower liquidity is probably a greater boon to long-term investors, especially in unsettled markets like these. You can see this in situations where firms have two share classes with different economic or voting rights and one is much less liquid (typically because it is closely held by a founder or controlling family). 

Take drinks firm Brown-Forman. It has voting A-class shares and non-voting B-class shares. They get the same dividends, yet the theoretically more valuable A currently trades at an 8% discount to the B. Or chemicals firm Henkel, which has non-voting preferred shares with dividends that are set to be just two euro cents higher than the ordinary shares. The less liquid ordinary shares are 13% cheaper.

For a more involved case, consider brewer Heineken. It is 50% owned by Heineken Holding, which has no other assets. These stocks pay the same dividends, yet the holding company trades at an 11% discount. Or for a slightly different variant, many Korean firms such as Samsung Electronics have a small float of non-voting shares that trade at a huge discount to the ordinary shares (there is a fund, Weiss Korea Opportunity (LSE: WKOF), that specialises in investing in these).

Not all cases are useful: brewer Carlsberg’s less-liquid A shares oddly trade at a premium to its B shares. But for private investors who don’t need the same level of liquidity as institutions, these situations can sometimes let you buy into major companies at a better price.

I wish I knew what a stock split was, but I’m too embarrassed to ask

A stock split happens when a company decides to increase the number of its shares in issue by giving existing investors additional shares for each share that they currently hold. The firm’s share price falls to reflect the enlarged share base and its market capitalisation stays the same. The total value of each investor’s shareholding remains unchanged as well, because they hold the same percentage of the firm after the split that they did before. 

For example, assume that a company has 100 million shares in issue and a share price of £50 per share. It carries out a 2:1 (or two-for-one) split, meaning that the investor ends up with two shares for every one they originally had. Then the total number of shares increases to 200 million and the share price falls to £25. The market cap stays at £500m and an investor that previously owned 100 shares worth £1,000 will now have 200 shares worth the same. All financial ratios such as earnings per share and dividends per share will obviously be halved.

It’s widely believed that stock splits improve liquidity, because smaller investors are now more able or willing to trade lower-priced shares. The argument for this is not very compelling: in practice, investors tend to buy or sell a certain value of shares (eg, £5,000) rather than a certain number (eg, 500), so it’s only if the price is very high (eg, £10,000 per share) that you’d expect a lower price to make a difference to how often it’s traded. The empirical evidence is mixed at best; some studies suggest that any change is short-lived and that the bid/ask spread – a more meaningful measure of liquidity than the number of shares that are traded – may get worse after a split. 

The opposite of a stock split is a consolidation or reverse split, which happens when a firm reduces the number of shares in issue. These are less common and usually the sign of a company trying to make a very weak share price look better.

Recommended

Avoid easyJet shares – there are better airlines to invest in
Share tips

Avoid easyJet shares – there are better airlines to invest in

EasyJet used to be one of Europe’s most impressive airlines. But now it is facing challenges on all fronts and losing out to the competition. Rupert …
16 May 2022
Value is starting to emerge in the markets
Investment strategy

Value is starting to emerge in the markets

If you are looking for long-term value in the markets, some is beginning to emerge, says Merryn Somerset Webb. Indeed, you may soon be able to buy tra…
16 May 2022
Britain’s ten most-hated shares – w/e 13 May
Stocks and shares

Britain’s ten most-hated shares – w/e 13 May

Rupert Hargreaves looks at Britain's ten-most hated shares, and what short-sellers are looking right now.
16 May 2022
Is the oil market heading for a supply glut?
Oil

Is the oil market heading for a supply glut?

Many people assume that the high oil price is here to stay – and could well go higher. But we’ve been here before, says Max King. History suggests tha…
16 May 2022

Most Popular

Get set for another debt binge as real interest rates fall
UK Economy

Get set for another debt binge as real interest rates fall

Despite the fuss about rising interest rates, they’re falling in real terms. That will blow up a wild bubble, says Matthew Lynn.
15 May 2022
High inflation will fade – here’s why
Inflation

High inflation will fade – here’s why

Many people expect high inflation to persist for a long time. But that might not be true, says Max King. Inflation may fall faster than expected – and…
13 May 2022
What the Ukraine crisis might mean for ESG investing
Advertisement Feature

What the Ukraine crisis might mean for ESG investing

The Ukraine crisis has brought many of the issues around ESG investing into sharper focus. Where does the sector go from here?
3 May 2022