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Splitsville: Why Big Stock Splits Usually Warn The End Is Near

Sometimes great stocks approaching their peaks flash too many sell signs to ignore. Sometimes they flash subtle ones.

One such sign is a fast series of big stock splits. Many investors see splits bullishly. Companies use stock splits to lower share prices. But you should treat them with caution.

Theoretically, lower prices mean more demand. A 2-for-1 split halves the price of a stock from $100 to $50 while doubling the number of shares outstanding. Investors who previously couldn't afford a share might now be tempted. (Companies can effect splits in ratios of up to 10-to-1 or more.) But a split does not change the current value of the company in any way.

There are reasons that companies like Apple (AAPL), Google (GOOG) and Priceline.com (PCLN) have share prices of $439 to $820. (The grandpappy of the stock split is Warren Buffett's Berkshire Hathaway (BRKA), with its Class A share price now topping $160,000.) These stocks attract investors willing to pay for quality. That might narrow the potential audience, but it tends to increase the smart-money sponsors that are backing the stock. Stock splits attract smaller investors. In effect, they change the neighborhood.

To be sure, early stock splits are often not a problem.

Stocks can and often do move higher after initial splits — particularly when they happen early in a bull market. But problems occur when companies enact multiple big splits — say, a 2-for-1 and a 3-for-1 — in a one- to two-year period.

This floods the market with a company's shares. IBD research shows a stock will often reach a price peak around its second or third split. Research also shows that only 18% of history's biggest winners had even a single stock split in the year preceding the start of their run.

One good example of a hot stock tripping on a stock split is Monster Beverage (MNST), once named Hansen Natural. Monster, one of the original energy drink success stories, jetted more than 4,000% from 2003 to 2006.

The company enacted its first stock split in August 2005 (1) , just a month after the stock first touched $100 per share (chart is split-adjusted). The stock's response shows why a single stock split, like most sell signals, is not a sign to cut and run.

Just after the split, Monster shares dropped through their 10-week line in heavy trade, but stopped a short distance below the line. The stock formed a new base, then broke out and moved higher.

The second, truly monster 4-to-1 split, occurred just after the stock punched through the 210 pre-adjusted price level in July 2006. (2) Shares responded immediately with a pullback to the 10-week line in heavy trade. Monster dived a few weeks later en route to a 53% correction.