Stock splits have increased as the U.S. market extended its bull run, but the actual benefits for investors are questionable.
As the market’s bull run gained steam in recent years, stock splits have been happening with increasing frequency. Is a split a ringing vote of confidence from company management? Or just eye candy for investors? Here’s a few things you need to know.
Take that pile of stock in front of you and double it, or triple it—heck, let’s get a little crazy and multiply it times 10. That’s essentially what happens when a company splits its shares. You have a lot more than you had before, at least in terms of one number on your account statement. But are you actually richer or otherwise better off? The short answer: Not necessarily.
Like the dividend payout, the split is a decades-old practice U.S. corporations keep handy when they want to throw a bone to the market. In a two-for-one split, one common scenario, investors receive one additional share for each share they already own; the stock price is halved—$50 becomes $25, for example—and the number of shares outstanding doubles.
Otherwise, not much else changes—the company’s market capitalization and other key financial metrics remain the same. Market professionals have long debated the merits of splits and whether investors realize any benefit, a narrative amplified recently by soaring prices for high-profile technology stocks.
One thing appears to be certain: U.S. companies are increasingly going “splitsville” with their shareholders. Through the first five months of 2014, approximately 27 U.S.-based corporations split their shares, compared with 32 for all of 2013, according to Schaeffer’s Investment Research. At that rate, this year’s total may reach the mid-60s, the highest since 2007 (though still well below the 1990s heyday). Check the calendar function on Trade Architect® for stock split dates (see figure 1).
FIGURE 1: SAVE THE DATES. The Trade Architect? calendar function can tell you how many stock splits (purple rectangles) and other corporate events are scheduled for a particular day. Source: TD Ameritrade. For illustrative purposes only.
Why do companies split shares? Psychology, for one. As a stock climbs and climbs, some investors, particularly smaller ones, may view the shares as too expensive and out of reach. A split, in theory, takes the price down to what may be a more attractive or accessible level, while also feeding a notion among existing shareholders that they have “more” than they did before.
Splits “allow people to buy more shares,” said Ryan Campbell, Content Manager with Investools®, an education affiliate of TD Ameritrade. When investors believe they can buy more shares at a lower price, “they seem to perceive that as some kind of a ‘deal’ for the stock, even though the value hasn’t really changed.”
Splits often pick up during strong periods for the broader market, as was the case in the ’90s and, more recently, in the current bull market that notched its fifth birthday in March.
“The theory is, a lower-priced stock makes it more affordable,” said Ryan Detrick, an analyst with Schaeffer’s, “although most serious traders would probably say it is all smoke and mirrors. My take is, splits do nothing in terms of adding value.”
Despite the skeptics, there is evidence that a split presents a bona fide “buy” signal. Since 1990, stocks averaged a return of 21% during the 12 months following a split, against an average gain of 8.9% for the S&P 500 over comparable periods, according to Schaeffer’s (see figure 2).
FIGURE 2: SPLITTING HAIRS. Over the past quarter-century, post-split performances for many U.S. stocks (left columns) tended to outpace broader benchmarks like the S&P 500 Index. Figures reflect performance through May 2014. Source: Schaeffers Investment Research. For illustrative purposes only. Past performance does not guarantee future results or success.
“There definitely does seem to be some outperformance” for post-split shares, Detrick said. Why? “Odds are, companies that split, more often than not, are solid companies,” he said.
Indeed, a “2-for-1 Index” tracked by the New York Stock Exchange’s parent company, has outpaced the S&P 500 in 13 of the past 17 years (see figure 3). The index, comprised of about 30 companies, aims to quantify the post-split outperformance that’s often seen over a two- to three-year period.
FIGURE 3: DOUBLE YOUR PLEASURE. The 2 for 1 index (ticker $SPLITS), which measures postsplit performance of U.S. stocks, has marched steadily higher in recent years, in step with a wider bull market. Source: TD Ameritrade, NYSE. For illustrative purposes only.
Stock splits can take many forms, although the most common are 2-for-1, 3-for-1 and 3-for-2.A company’s management and its board must approve a split, then publicly announce their intention to do so; the actual split usually takes place within a few days or weeks.If you’re an investor in a company that does a 2-for- 1 split, you’ll receive one additional share for each share you already own, likely deposited directly into your brokerage account (because the stock price is split accordingly, the value of your stake won’t really change due to the physical split alone).Less common is the reverse split, in which a corporation reduces the number of outstanding shares, often in an attempt to prop up a sagging stock price.
All of which raises sort of a chicken-or-egg conundrum: Are certain stocks rallying as a direct result of a split? Or does the post-split performance merely reflect fundamentals that were already in place, and likely would have pushed the shares higher anyway?
Conversely, an escalating number of splits could be construed as a warning of runaway bullishness, Detrick said. In the mid-’90s, the U.S. market averaged about 80 splits annually, then jumped to more than 153 a year late in the decade and finally peaked at 175 in 2000. The following year, after the tech bubble burst, there were a total of 57 splits.
For investors, seizing on a split as the deciding factor in whether to buy a stock is inadvisable. For traders, potential benefits of any split-related strategies have grown murkier. Years ago, it was common to buy shares after a split because the stock tended to rise to the pre-split price within a year, Campbell said. More recently, it’s unclear if that phenomenon still holds true.
There was also the “Chuck Woolery strategy,” Campbell added. But, much like the ’80s dating show and its amiable host, what was once ubiquitous now seems of a distant era. Under this tack, you’d buy a stock about two weeks prior to the announced date of a split, then sell it about two days ahead of the actual split—the “Two and Two” trade, to echo Woolery’s commercial break signoff phrase.
“The stock tended to rally into the split, then sell off after the split,” Campbell said, noting that the effect was especially pronounced during the dot-com bubble. But, like many short-term trades or arbitrage opportunities, patterns changed.
“Traders had created a self-fulfilling prophecy,” Campbell said. “Investors are savvier today than they were in the ’90s and early 2000s. They realize the value of the trade isn’t changed through a split, so the excitement over splits isn’t there.”
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