When One Plus One Can Equal More Than Two
About 50 years ago, the late great economists Merton Miller and Franco Modigliani broke fresh ground in the study of corporate finance by proving that a firm's value is determined by its investment policies, not its financing decisions. Also, it does not matter how much relative debt or equity a company maintains, and the issuance of stock, bonds, warrants, and dividends has no effect on the company's aggregate worth.
With that said, and before looking at whether stock splits somehow add value to a corporation, it is useful to consider why companies split their stock. And there are three main arguments offered by stock split proponents:
1. To bring the share price of a skyrocketing stock back to earth, enabling the smaller, retail investor to purchase shares he might otherwise ignore because he couldn't afford to buy at least 100 shares of it at the elevated price.
2. To signal to the world that the company is a high-flyer and attract attention from stock analysts who might otherwise ignore it.
3. To improve liquidity and smooth out volatility in the stock by increasing the number of shares available to trade, and attracting new money to dilute the influence of institutional investors. It is assumed that the bid-ask spread will tighten, and volatility will be tempered in the presence of the larger number and more diverse base of potential investors.
So should investors ignore stock splits?
Absolutely not. Although the underlying principles upon which splits are based may seem without merit, there is a market opportunity in these cases that should not be overlooked. It appears that stocks that split tend to go up in both the short and long run by significantly more than the expected "buy-and-hold" amount. In fact, a 1996 study which tracked 1,275 listed stocks between 1975 and 1990 that split 2 for 1 showed that the immediate returns are 3.38 percent higher than what otherwise might be expected. More importantly, splitting firms generate excess returns of 7.93 percent in the first year after the split and excess returns of 12.15 percent in the three years following the split. And a follow-up study in 2002 confirms the findings of the initial study.
So why not take all your money and only invest in stocks that split?
Well there is really a different and far more important question: Can an investor rely on a single indicator, particularly when there appears to be such a high probability of success? This is an important question with no easy answer.
In the case of buying every stock that splits, there is a danger in that some split stocks will not show an excess return, and one ought to consider carefully all relevant variables before committing capital to a position. In particular, if one is looking for a short term pop, the risk is much higher of suffering a loss. Those who can wait for a year or longer are far likelier to appreciate a gain, but there are no guarantees, of course, that any stock will be worth more in the distant future than it is today.
That caveat being given, the excess returns when a company splits its stock appear to be substantial and reliable and a good place to start as any in constructing a profitable investment strategy. While researchers seem stumped as to why companies want to split their stock, to an investor searching for profits, it doesn't much matter as long as the end result is one that enriches.
Maybe the answer is that most companies with high prices that split their stock are simply good companies; the fact that a company's stock price is high is not always evidence that it is a good company, but in many cases it is the best evidence. After the stock split, a good company is still a good company, and there is no reason to think its share price will stop appreciating in value. The lesson here seems to be, at any price buy a good company, but especially at a split price.
* * * * *
With that said, and before looking at whether stock splits somehow add value to a corporation, it is useful to consider why companies split their stock. And there are three main arguments offered by stock split proponents:
1. To bring the share price of a skyrocketing stock back to earth, enabling the smaller, retail investor to purchase shares he might otherwise ignore because he couldn't afford to buy at least 100 shares of it at the elevated price.
2. To signal to the world that the company is a high-flyer and attract attention from stock analysts who might otherwise ignore it.
3. To improve liquidity and smooth out volatility in the stock by increasing the number of shares available to trade, and attracting new money to dilute the influence of institutional investors. It is assumed that the bid-ask spread will tighten, and volatility will be tempered in the presence of the larger number and more diverse base of potential investors.
So should investors ignore stock splits?
Absolutely not. Although the underlying principles upon which splits are based may seem without merit, there is a market opportunity in these cases that should not be overlooked. It appears that stocks that split tend to go up in both the short and long run by significantly more than the expected "buy-and-hold" amount. In fact, a 1996 study which tracked 1,275 listed stocks between 1975 and 1990 that split 2 for 1 showed that the immediate returns are 3.38 percent higher than what otherwise might be expected. More importantly, splitting firms generate excess returns of 7.93 percent in the first year after the split and excess returns of 12.15 percent in the three years following the split. And a follow-up study in 2002 confirms the findings of the initial study.
So why not take all your money and only invest in stocks that split?
Well there is really a different and far more important question: Can an investor rely on a single indicator, particularly when there appears to be such a high probability of success? This is an important question with no easy answer.
In the case of buying every stock that splits, there is a danger in that some split stocks will not show an excess return, and one ought to consider carefully all relevant variables before committing capital to a position. In particular, if one is looking for a short term pop, the risk is much higher of suffering a loss. Those who can wait for a year or longer are far likelier to appreciate a gain, but there are no guarantees, of course, that any stock will be worth more in the distant future than it is today.
That caveat being given, the excess returns when a company splits its stock appear to be substantial and reliable and a good place to start as any in constructing a profitable investment strategy. While researchers seem stumped as to why companies want to split their stock, to an investor searching for profits, it doesn't much matter as long as the end result is one that enriches.
Maybe the answer is that most companies with high prices that split their stock are simply good companies; the fact that a company's stock price is high is not always evidence that it is a good company, but in many cases it is the best evidence. After the stock split, a good company is still a good company, and there is no reason to think its share price will stop appreciating in value. The lesson here seems to be, at any price buy a good company, but especially at a split price.
* * * * *
posted by Bob Moser at
9:46 PM
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