There are few announcements that get stock investors as excited as an upcoming stock split. They’re often taken as a portent of good thinks for years to come for the investors who hold shares the day before: solid sales and revenue growth for the company, an upward trajectory for the stock price, and the prospect of even more splits in the future.
According to two studies by David Ikkenberry, now Dean of the Leeds Business School at the University of Colorado, stock splits do usually portend an extended run of healthy gains for a stock. In 1996, he looked at 1,275 2-for-1 stocks splits from 1975 through 1990.
He found that the stocks outperformed similar-sized companies in the same sectors that did not split by 8% in the first year and by 16% after three years. A 2003 follow-up study, covering stock splits from 1990 to 1997 and including 3-for-1 and 4-for-1 splits, found similar results.
Why does this happen? First, let’s talk about what stock splits actually mean and what they don’t. Companies usually decide to split their stock after a significant increase in its price. The purpose is to reduce the price to make it affordable for more investors to acquire, which they usually do in multiples of 100 shares.
The idea is that company management wants to be sure to tap into the demand that can come from individual investors, in addition to the demand from institutions, who are often willing to buy good growth stocks at almost any price.
While stock splits increase the number of shares, the price comes down proportionately so that their holdings have exactly the same market value at the moment the stock splits. But stock splits often do pique more investor interest, largely because they call attention to the company’s results. It is the extent to which management has accurately estimated the untapped demand for the stock, as well as its future prospects that determines the stock’s performance.
But, as the history of business will attest, spectacular rates of growth are difficult to continue. Even just theoretically, there’s a limit to how many more widgets any company can sell.
Markets change, economies change, management changes; and sooner or later, nearly every growth stock becomes a more ordinary performer that can no longer meet the aggressive expectations that prompted more investors to buy at a higher price – and at that point, the stock price peaks and then languishes or declines.
Unfortunately, there’s no rule of thumb to tell whether a split is a sign of an impending change in fortune for a stock. In general, investors should always be at least a little skeptical about buying a stock that has a long history of spectacular returns, but that alone doesn’t mean investors should stay away.
There is one kind of stock split that is a fairly reliable red flag: the reverse split. Reverse splits work exactly opposite to ordinary splits. They reduce the number of shares existing investors hold and raise the price. The motive is usually to maintain standards for listing on an exchange or inclusion in a stock index, or to be eligible for purchase by institutions. Naturally, reverse splits only occur after a stock has fallen a great deal in price.
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Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.