Cash in on Stock Splits

There are no sure things in the stock market. But if you're looking for an area where the odds of making a market-beating profit are in your favor, consider buying companies that split their stock.

In theory, a stock split has no impact on the value of your shares. When a company with, say, one million shares outstanding trading for $100 per share completes a two-for-one split, it ends up with two million shares selling for $50 apiece. The company is still worth $100 million, and your piece of the company is worth the same amount before and after the split. Moreover, a split does not affect a stock's valuation. A stock with a price-earnings ratio of ten or a dividend yield of 3% will still sport a P/E of ten and a yield of 3% after a split.

In reality, though, companies that split their shares tend to outperform the market for nearly three years after a split, says Neil Macneale, editor of the newsletter 2 for 1. The split itself doesn't create value, adds David Ikenberry, dean of the Leeds School of Business at the University of Colorado in Boulder and the author of several academic papers on splits. But it's an indicator that executives are unusually confident about their company's potential. "Stock splits only happen at times when the company perceives its share price is too expensive for the average investor and when the board of directors thinks it's only going to get higher," Ikenberry says.

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Macneale has proved the value of this theory with his own portfolio. Seventeen years ago, he started investing his retirement account in 30 stocks that had announced splits, buying one new stock each month and selling the oldest, and reporting his recommendations in his newsletter. From 1996 through 2012, his portfolio beat the market 13 years out of 17. Over the ten-year period that ended May 31, Macneale's picks returned 13% annualized, according to the Hulbert Financial Digest, compared with 8% annualized for Standard & Poor's 500-stock index.

Macneale doesn't invest in every company that divides its stock. Some, he says, announce splits merely to get attention, and others are simply overvalued. But among the three or so companies that announce splits each month, he usually finds at least one that appears to be cheap based on its price relative to earnings or to book value (assets minus liabilities) or both.

If you want to bet on splits, you can choose from two approaches. Macneale's strategy is to invest in companies that have already announced splits. The NASD makes it easy to find prospects by publishing a listing of upcoming splits. However, you can also try to handicap which stocks are likely to split by searching for those that have soared beyond $100 — a level that often turns off small investors — and then checking to see if the company has a history of splitting its shares.

Companies such as MasterCard (symbol MA) and Google (GOOG), for instance, sell for high absolute share prices, but they have proved reluctant to split. IBM, on the other hand, has split its stock 15 times in its corporate history and, at $192.25, it may be ripe for another round. (All share prices are as of July 10.)

Here's a look at six attractive stocks: three that have already announced splits and three that seem ripe for splitting. Plus, the companies are attractive in their own right, regardless of how they handle their stocks.

Sure things

American States Water (AWR) has been keeping taps flowing in several Southern California communities since 1929. The company has also been generous to shareholders, increasing dividends every year for the past 59 years. This year, the San Dimas, Cal.-based utility went an extra step. In addition to hiking its quarterly dividend 14%, to 40.5 cents per share, it announced a two-for-one split that takes effect in September. Although analysts expect American States' double-digit earnings growth rate to slow, they may be underestimating the company's potential. In May, the company won approval from California regulators for an average 3.4% rate hike. And on June 12, American States announced that it will buy assets of the Rural Water Co., which brings it into the agriculture-rich San Luis Obispo area. At $56.24, the stock sells for 20 times estimated 2013 earnings and yields 2.9% (based on the new dividend rate).

Like trains? Then you'll love Westinghouse Air Brake Technologies (WAB). The Wilmerding, Pa., company, nicknamed Wabtec, makes and services all sorts of locomotive parts and rail electronics. Business has been booming, and profits have doubled over the past two years, as countries around the world expand and update their transportation systems for both freight and passengers. Wabtec's backlog continues to grow, with Australian rail systems placing large orders this spring. The company recently hiked its dividend by 60%, to 16 cents annually, and split its shares two-for-one on June 12. At $54.76, the shares sell for 18 times estimated 2013 earnings, a reasonable P/E given that analysts expect Wabtec to generate earnings growth of 15% annually over the next few years.

When consumers don't pay their bills, someone needs to collect, and that's what Portfolio Recovery Associates (PRAA) is all about. The Norfolk, Va., firm buys defaulted debts from banks at a discount and makes money by convincing consumers to pay up. In the first quarter of 2013, profits soared 52%, to $39 million, from the same period a year earlier. Analysts expect profits to continue growing at a 14% annual pace for the next several years. The stock, at $139.62, sells for 15 times projected 2013 earnings and is set to split three-for-one on August 1.

Potential splitters

Many investors worry that "the cloud" could disrupt old-line technology suppliers such as International Business Machines (IBM). But UBS analyst Steven Milunovich thinks the future is bright for Big Blue, which has transformed itself from a maker of large mainframe computers to a service company that helps Main Street deal with the rapid pace of technological change. Although earnings rose just 3% in the first quarter, chief executive Ginni Rometty says that's partly because of delays in a few big deals that IBM expected to close. Those pending deals are likely to goose upcoming quarterly results. Analysts expect earnings to climb 10% annually over the next few years. At $192.25, the stock trades for 12 times estimated 2013 earnings and is at roughly the same level it was in 1999, right before IBM's last split.

Another century-old industrial giant, 3M(MMM), is also within spitting distance of the price at which it last divided its shares. The St. Paul, Minn., company, which makes everything from light bulbs to cleaning supplies, recently said it is aiming to hike profits by 9% to 11% per year over the next several years. Analysts think it's got a good chance of hitting that mark. At $113.43, the stock sells for 17 times estimated 2013 earnings and yields an above-average 2.2%.

Profits at Panera Bread (PNRA), a chain of casual restaurants, have been rising as consistently as its dough. Earnings rose 29% in 2012 and another 17% in the first quarter of 2013. And analysts see long-term profit gains of 19% a year. At $188.32, Panera's stock is three times higher than it was the last time the St. Louis-based company split its shares, in 2002. The shares aren't cheap, trading at 27 times projected 2013 profits. So Morningstar analyst R.J. Hottovy thinks it's best to buy the stock on pullbacks. "Panera is one of the more compelling long-term growth stories in the restaurant space," he says.