What are stock splits and are they good for investors?

Jason Zweig believes that shareholders who love stock splits are like 'Yogi Berra, who wanted his pizza cut into four slices because "I don't think I can eat eight." According to Zweig, companies that 'split their stocks treat their investors like dolts'.

However, there are two sides or the story here. Some research suggests that investors can beat the market by investing in companies that split their stock. So are stock splits good or bad for shareholders?

What is a Stock Split?

A stock split is a corporate action whereby a company divides its existing shares into multiple shares. For example, a 2-for-1 split means that the stockholder will have two shares for every share held previously. This excites some investors. Back in 1999, Exodus Communication underwent three 2-for-1 splits in one year, prompting one shareholder to proclaim that "I'm going to hold these shares until I'm 80, [because] after it splits hundreds of times over the next years, I'll be close to becoming CEO."

This investor missed the point. The number of shares he held did increase, but the price of each individual share declined. Indeed, a 2-for-1 split would cause the number of shares to double, but the share price would halve. All other things being equal, the market capitalisation of the company would remain the same. A pizza actually serves as a useful analogy here. You can split one pizza into as many slices as you like, but at the end of the day you would still have just one pizza.

Apple Inc: 7-for-1 split - June 9 2014

Lets use Apple as an example. Apple underwent a 7-for-1 split stock split in June 2014. Before the split, the firm traded for more than $650 per share. The price reduced to $93.70 as a result of the split and the number of shares outstanding increased sevenfold.

If you owned ten shares in Apple before the split, your position would have been worth around $6500 both before and after the split. This is because each share became worth one-seventh of the pre-split price, but shareholders would have seven times as many shares.

Why do Stock Splits take place?

A stock split usually takes places when companies want to make their shares more affordable. Lets stick with the Apple example. You could have gone on holiday with the $650 it would have cost you buy just one share in Apple before the stock split. The price of $93.70 following the 7-to-1 split was more affordable.

Stock Splits can also increase the liquidity of a stock. Very large spreads can occur when stocks get into the hundreds of pounds per share. For example, Warren Buffett's Berkshire Hathaway has never had a stock split. It currently trades for a whopping $224,485 per share and the spread is $1109. This is another reason stock splits may make it easier for smaller investors to buy shares.

How does a Stock Split influence the share price?

Several studies have suggested that the average stock undergoing a split outperforms the market for upto three years following the split. For example, David L. Ikenberry (1996) tested two portfolios: one portfolio of stocks undergoing a stock split; and one portfolio of stocks that did not split. He found that 'splitters' tended to beat 'non-splitters' by 8% on average in the first year after the split, and 12.5% in the three years following the split (see table below).

More anecdotally, Neil Macneale - editor of an investment-advisory service called '2 for 1' - built a portfolio that only contained stocks that have recently split their shares. According to the Hulbert Financial Digest, that portfolio has produced a 14% annualised return, far outpacing the 8% gain of the Standard & Poor's 500-stock index (see here). To give just one case study - Apple has appreciated by 22% since its split in June, beating the market by 25%.

Source (Ikenberry: 1996)

Why does this happen?

Kalay and Kronlund (2012) believe that a stock split could be a sign that managers are confident that 'the firm is doing well'. They hypothesise that companies have a target range for where they would like their shares to trade. If the price is too high, the stock may be unattractive to smaller investors. If the price falls below a certain threshold, it may fail to meet an exchange's minimum price requirement, or be excluded from the holdings of institutional investors with minimum-price rules.

Kalay and Kronlund argue that 'if managers employ splits to maintain a desired share price range, then they are more likely to split the firm's stock when they believe the stock price will not otherwise decline to the targeted price range. In this case, managers split their firm's stock when they are optimistic about the firm's future performance.' Indeed, Kalay and Kronlund find that companies that split their stock have tended to grow their earnings for longer and more consistently than companies that do not split.

Furthermore, Ikenberry's research suggests that 'splitting' companies usually beat the market in the year preceding the split. He observed that 'splitting' companies appreciated by 54% on average during the year before the split, whereas the S&P 500 returned 22.3%. These companies may therefore benefit from the momentum effect - whereby stocks that go up keep on going up. Shareholders who invest in stocks that undergo splits could be harvesting the momentum premium in the market.

Conclusions

So are stock splits good for investors? Logic suggests they should make no difference. Shareholders end up owning a larger number of shares as a result of a stock split. However, the value of each share also drops. A 3-for-1 split creates three times as many shares, but each share is worth just one third of its pre-split price. However, academic research suggests that stock splits indicate that the management believes a company is capable of growing its earnings, and stocks that do split have indeed gone on to beat the market.

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