It may be less common in this digital era, yet it is still worth learning about these securities.
On the other hand, many investors, including those participating in employee stock purchase plans and dividend reinvestment plans, may suddenly find themselves with shares of businesses they didn’t quite understand.
The answer is a little of both. But, it’s less complicated than it may seem at first. A few basic facts will help you understand tracking stocks and how they could fit into your portfolio.
The Understanding of Tracking Stocks
A tracking stock is a special type of stock to represent a particular division or segment of the business. Tracking stocks give investors the opportunity to value specific aspects of a larger enterprise on different terms and with different price-to-earnings (P/E) multiples.
Investors can speculate on specific departments or segments of a company. Meanwhile, management can retain control of the segments without having to sell ownership or create a separate legal entity.
There are also pros and cons related to the tracking stocks. Here is the explanation of the pros and cons.
The Pros of Tracking Stock
A tracking stock can allow management to unlock value by increasing the total stock market capitalization and an enterprise value of the business through expansion in the overall P/E ratio.
It also gives the board of directors an appreciated currency in the form of two different shares. In addition, it can be used when making acquisitions. Therefore, the business can expand while giving up less intrinsic value.
For this reason, it can be used to buy other investments, pay down debt, send their children to college, and so on. As a result, it retains control over the tracked operating segment or business.
The Cons of Tracking Stock
Tracking stocks often have greatly reduced or non-existent voting rights. An owner of a tracking stock might not even own the specific aspect of the operating segment.
Investors would feel the effect of this in the event of corporate bankruptcy. Even if the division associated with the tracking stock, it was extremely profitable and growing rapidly.
For instance, the bankruptcy of Eastman Kodak in 2012 did not affect its former subsidiary Eastman Chemical.
If the market goes south, the tracking stock can be absorbed back into the main stock at a price. Kodak was the real example of why its wealth was totally destructed. Hence, it may appear unattractive to owners of the stock, owner of the original corporate stock or both.