Market regulation

Did you hear the one about a guy who orders a pizza, and the chef asks him if he'd like it cut into six pieces or eight pieces?

"Cut it into six," the guy says. "I'd never be able to eat eight."

The pizza story is an old joke, but pretty much the same thing just happened at the Tokyo Stock Exchange (TSE). On March 8th, the Asahi Shimbun reported:

In the wake of wide share price fluctuations attributed to large-scale stock splits, the Tokyo Stock Exchange on Monday set new guidelines to restrict the tactic.

Aggressive splits by Livedoor Co., for example, led to a substantial increase in the relative share prices and, as a result, a rise in market capitalization.

If you're familiar with stocks, that statement probably strikes you as a bit fishy — because stock splits have no inherent effect on share price or market capitalization.

Generally speaking, the total equity value of a company (its "market capitalization") equals the number of shares of stock it has outstanding, times the price of a single share. If Acme Corporation has issued a million shares of stock, and Acme stock is trading at $100 per share, then Acme's market capitalization is $100 million. Easy, right?

But what happens if Acme decides to split its stock? In a normal split, a company essentially increases its number of shares while proportionately reducing their value. Returning to our above example, let's say Acme decides to split its stock "two-for-one". That means it's going to turn its one million shares worth $100 each into two million shares worth $50 each.

Notice that the split doesn't change Acme's market capitalization at all. One million times $100 is the same as two million times $50. (And, in response to a comment on this post, note that the value of individual shareholders' investments isn't affected, either: If you held 100 shares of Acme worth a total of $10,000 before the split, you'll have 200 shares still worth a total of $10,000 afterwards.)

Yet the TSE claims the practice drives share prices higher, and the Asahi isn't calling them on it. What's going on? Well, it's not that they don't understand how splits work. Despite everything I just wrote, stock splits actually do tend to spark short-term share price increases.

Why? To answer that question, consider the main reason companies use splits: to keep their stock price in a range where individual investors can easily buy shares.

For example, look at Dell. Since it went public in 1988, Dell has increased dramatically in value, but it's also split its stock several times. A single share from its IPO has now, after all those splits, turned into ninety-six shares. As a result, instead of costing $3,696, a single share of DELL stock costs only $38.50. That low price makes it easier for investors — especially small, individual investors — to buy and sell Dell stock.

So, because spilts can signal that a company thinks its stock price is headed up, investors tend to buy shares in companies that announce splits. And this increased demand for a company's stock can drive up the share price.

The Asahi article focuses on this phenomenon as a reason for the increased regulation:

However, share prices tend to fluctuate immediately after a stock split largely due to an imbalance between demand and supply.

The actual number of shares available for trading is generally limited shortly after the stock split, because it can take more than a month for newly issued shares to be delivered to stockholders after necessary procedures, such as printing stock certificates.

The number of shares post-split isn't any more "limited" than it was beforehand. Neither is there an "imbalance between demand and supply". The rising share price keeps them in perfect balance. And while a company may get a short-term price boost by splitting its stock, the key word is "short-term": If it doesn't actually deliver earnings growth, investors will dump its shares as quickly as they bought them. The split hasn't increased the fundamental value of the company, any more than a Yankees uniform improves your ability to play baseball.

In the case of Livedoor, it hasn't just split its stock, it's also aggressively acquired other companies, doubling its annual revenues for several years running, and growing from a small web design shop into a diverse IT, networking, and e-commerce company. (Indeed, Livedoor's now at the center of a front-page takeover battle, as it tries to acquire the much larger Fuji Television company.) You don't get that kind of real growth by splits alone.

The Asahi article also cites another supposed problem with splits:

If a company executes a stock split soon after it issues bonds with stock warrants, the stock split may benefit only the bond subscribers, who can quickly convert the warrants into new shares.

The problem here is not the split, but the warrants themselves, which give new shares to a select group of investors while diluting the value of existing shareholders' stakes in the company.

What's really at work here is a reluctance to let the market do its job of reflecting investor opinion. The TSE has essentially decided that share price behavior in the wake of a split announcement is inappropriate, and it's trying to bring it more in line with the way it thinks stocks should trade. Notably, by restricting splits, the TSE is making it more likely for companies to keep their share prices high — shutting small individual investors, and their supposedly irrational behavior, out of the market.

In this way, the TSE regulators resemble failed presidential candidate John F. Kerry, who in a recent speech deplored the ability of ordinary people to opine on, and influence, the political process:

There has been a profound and negative change in the relationship of America's media with the American people... If 77 percent of the people who voted for George Bush on Election Day believed weapons of mass destruction had been found in Iraq — as they did — and 77 percent of the people who voted for him believed that Saddam Hussein was responsible for 9/11 — as they did — then something has happened in the way in which we are talking to each other and who is arbitrating the truth in American politics... When fear is dominating the discussion and when there are false choices presented and there is no arbitrator, we have a problem.

Kerry doesn't explain where he got his 77% number, but it doesn't really matter. There is an arbitrator in America's national debate: the ability each of us has to listen to, judge, and support or denounce various speakers and their statements.

Kerry simply doesn't trust ordinary people to interpret the news on their own, just like the TSE doesn't think small investors can make rational investment decisions. The ironies here are many, and rich. In Japan, much of the economic malaise dating back to the late 1980's has been due to the irrational behavior of large, institutional investors, like banks, who maintained "cross-shareholdings" in friendly, but money-losing, companies long after ordinary investors would have cut their losses. And in America, the increasing number, availability, and prominence of nontraditional information sources has made Americans better-informed than ever before, while holding the mainstream media itself to a higher standard.

Yet in both cases, the claim is that more regulation, more oversight, more guidance is needed. And in both cases, the marketplace — of stocks, or of ideas — will do just fine on its own.