Individual investors tend to get excited about stock splits. The conventional wisdom holds that stocks that have split tend to outperform the market. Conversation often centers on when a particular company will split its stock, whether you should buy before or after the split, and when one should sell a stock after it has split. In the late 1990s, businesses that split their stocks most often included extremely profitable and successful, but also very popular companies. This invites discussion of whether Fools should view stock splits as an unparalleled opportunity to mint money or just another chunk of Wall Street's received wisdom that should be ridiculed.
A study called "What Do Stock Splits Really Signal?" in September of 1995 examined the performance of stock splits on the New York Stock Exchange and American Stock Exchange from 1975 to 1990. Authors David Ikenberry and Earl Kay Stice discovered that companies that split their stock outperform the S&P 500 by 7.94% in the first year following the announcement. A full 3.38% of that outperformance occurs in the first five days after the split. The most significant excess returns over the long-term tend to occur in small companies that have split their shares, as opposed to large companies. With a sizeable 6% of companies on the New York Stock Exchange and American Stock Exchange splitting their stock every year, it would appear that this outperformance is statistically significant.
Because stocks tend to outperform the market after a stock split, does it therefore make sense to purchase a company based solely on the fact that it is going to split its shares? Before we can reach a conclusion here, we need to understand why stocks that have split tend to outperform the major indexes. There are two main theories in academic circles to explain the stock-split effect: implicit communication and affordability.
Implicit communication is the idea that the stock split is somehow a signal from management or the board of directors to investors that they anticipate good things over the next few months that will drive the stock price even higher. Technically defined, management is communicating "its optimistic expectations about future cash flows."
Affordability is simply maintaining the share price within a certain range. Although share price might appear to be an arbitrary thing, different share prices tend to communicate different things to investors. Even though it is completely irrational and unFoolish, an investor with $4,000 to invest will often choose to purchase 800 shares of a $5 stock over 40 shares of a $100 stock because the $5 stock is "cheaper." When the share price gets to about $50 or so, many small investors view the stock as "out of their price range" because they could only buy a few shares, leaving them to concentrate on stocks that are more attractively priced.
All of this theorizing can get away from the core reason a company is "forced" to split its stock. A company splits its stock when the price has appreciated. Not very many companies have ever decided to do a three-for-one split when the stock is down 50%; most have split their stock after it has gone up significantly. One cannot view the stock split outside of the rapid appreciation of the stock's price -- the two are intimately connected.
The same factors that cause a stock to rapidly appreciate drive companies to split their stock. Strong growth in earnings, revenues, cash-flow, profit margins, and other significant news often stand behind the companies that decide to split their stock. Companies doing stock splits tend to have very high Relative Strength ratings, another by-product of the good news pouring out from corporate headquarters. As David Gardner wrote in The Motley Fool Investment Guide, strong price appreciation means that "things are better than they ever have been before."
So, if we have underlying fundamental changes driving stock-price increases, and concomitantly driving the stock splits, of course stocks that split, as a group, will outperform the market price-wise -- they are outperforming the market earnings-wise, cash-flow-wise, revenue-wise, and so on. Attributing the price increase to the stock split and not the underlying fundamentals of the business is the old ice cream/monsoon analogy.
One sharp statistician figured out many moons ago that the increase in the number of ice cream cones sold in New York City correlates quite well with the increase in the number of deaths in Southeast Asia. Should people stop buying ice cream cones in an attempt to save lives? Of course not. They should simply recognize that summer in New York City is monsoon season in Southeast Asia and that these two events are only connected via the underlying weather phenomenon, not through any direct linkage. So it is with stock splits and stock price appreciation -- underlying positive change in the fundamentals drives both phenomena. Independently, they are not related.
Stock splits have slowed considerably the past year.
Randy Befumo is a former Motley Fool writer/analyst. The Motley Fool is investors writing for investors.
