Why Stock Splits Are Nothing Special

If you've been investing long enough to remember the tech bubble of the late 1990s, you'll recall that one of the surest signs of a success story in the making was when a company decided to do a stock split. Having gone through two bear markets since then, investors seem to be less gullible than their naive counterparts from a decade ago.

From a corporate standpoint, stock splits don't have any real impact at all. For instance, if a company does a 2-for-1 stock split, it doubles the number of shares outstanding, but it doesn't change the intrinsic value of the company at all. Therefore, what should happen is that the post-split shares should be worth exactly half of what the pre-split shares were worth.

What should happen, however, isn't always what does happen. Take a look at the stock histories of companies like Yahoo! and Amazon.com during 1998 and 1999, and you'll see plenty of situations in which share prices jumped immediately after a split and never looked back -- or at least not until the tech bust.

Full of sound and fury ...
In the past, there were some positives to stock splits that might explain some of the appeal they had. In particular, stock splits made a huge difference to average investors. At a time when it was virtually impossible to trade stocks in less than 100-share increments, a share split made it much less expensive for small investors to build positions in formerly high-priced stocks.

The more important impact of a stock split, however, was psychological. By announcing a split, a company's management implicitly assured investors that they foresaw the share price continuing to rise over time, and certainly would be able to sustain post-split levels. As long as herds of investors bought that viewpoint, then split announcements were self-fulfilling prophecies, acting as effective PR campaigns to bolster share prices.

... signifying nothing
Now, though, those positives aren't as important. Discount brokerage accounts make it easy to trade small numbers of shares, and low commissions even make it economically feasible to do so. And having lived through the experience of seeing companies split their shares multiple times only to crash and burn during the tech bust, investors can recognize that stock splits are no guarantee of success.

Just a quick look at recent stock splits over the past month demonstrates this lack of response quite well:

Source: Yahoo! Finance.

These moves look appropriately random and insignificant. The biggest move, from Lufkin Industries, came on a day on which the S&P 500 rose 2.5%.

Splits haven't lost all of their luster, at least among those stocks that command the attention of large numbers of investors. On May 12, Baidu (Nasdaq: BIDU) rose 9.5% after splitting its stock 10-for-1. But even there, within a week, the shares had given back all of that gain and then some.

How to handle splits
When you heard about a split 10 years ago, the first word out of your mouth would have been, "buy!" Now, the smarter short response is to ask why. In particular, ask yourself what's motivating the company's decision to split its shares. Does the split make any sense from a corporate standpoint, or is it just a gimmick to try to goose share prices for no real fundamental reason?

Stock splits may sound like exciting news, but more often than not these days, they're a non-event. Don't get caught up in the hype, and instead realize that no matter whether you own more shares at a cheaper price or fewer shares at a higher price, the key to profiting from your investment isn't a one-day jump from a stock split, but rather how the company performs over the long haul.

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