Trading Stock Splits For Big Profits
Trading Stock Splits:
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Stock Has Split
Alert Message
This company stock split postsplit shares for presplit shares.
Alert Definition
Companies usually split their stocks by a factor of 2:1, 3:2 or some
other ratio to cut the price and increase the number of outstanding
shares. The stocks do not truly become any cheaper because a $1
investment buys the same share of the company’s earnings before and
after the split.
So why do they do it? Conventional wisdom holds that companies split
their stocks after reaching a threshold price so that they are priced
low enough for individual investors to buy. Once a stock price shoots
higher than $100, for instance, evidence suggests that individuals tend
to back off from buying because they are hard pressed to come up with
the $10,000 or more needed to buy in round lots of at least 100 shares.
For years, university finance professors have repeatedly reported in
research papers that splits are a neutral event for stocks — neither
positive nor negative — even though shares regularly rally after a
split announcement.
However, research published in 1996 by some Arizona professors suggests
that splits signal positive information to investors, and that the
initial jump in prices actually underestimates the good news. In a
paper published in the Journal of Finance, these professors showed
that stocks that split performed eight percentage points better than
the mean of all stocks in the first year after the effective date of
the split. After three years, the split stocks’ returns were 16 percenta
ge points better than the mean, they reported.
The explanation: Companies that split their stocks have typically
enjoyed a big run-up in share prices, and the split announcement is a
heads-up to investors that the board expects the good times to keep on
rolling. After all, a soundly managed company that believes its stock
is overvalued after a run-up isn’t likely to announce a split because
it expects the price to slip back on its own.
In another research paper published in 1996, a group of San Diego
researchers reported a simple way to produce above-average returns
with splits: On the last day of the month, buy all stocks that split
2-for-1 or 3-for-2 in that month, and hold them for three months.
The strategy returned, on average, annualized gains of 32.3% from 1975 to 1995, compared with annualized gains of 17.6% for a benchmark group of 3,300 other stocks.
Of course, this strategy works only if a small subset of investors
follows it. If investors in general buy stocks announcing splits, the
increase in demand will drive the stock price up to the point where
there is no excess return left.
Most finance professors continue to believe that there is no
"exploitable anomaly" in companies that split their stocks. To learn
more about the effect of splits on your stock, go to Historical Charts
in Stock Research, click in Options, check the box to show Splits,
and look at what has happened to your stock after each split in the
past.
