Are Stock Splits Really a Good Thing?

09/21/2012 9:30 am EST

Focus: MARKETS

Richard Moroney

Editor, Dow Theory Forecasts

Investors consider stock splits to be a good thing, but generally have never done the math to see if it's really true. Now it's been done for you, and the thoughtful answer to this intuitive question is finally revealed, thanks to Richard Moroney of Dow Theory Forecasts.

Investors like stock splits.

Logic suggests they shouldn’t care, because splits don’t affect the value of an investment. Suppose you own 100 shares of a $50 stock that splits 2:1. After the split, you’ll own 200 shares of a $25 stock—the same $5,000 position you held before.

But you don’t invest in a vacuum, and the effect of stock splits cannot be fully explained by multiplying share counts and dividing stock prices. Numerous studies have shown that stocks tend to outperform after announcing stock splits—even if investors bought shares several days after the announcement. In contrast, stocks that announce reverse splits, in which they consolidate multiple shares into a single, higher-priced share, tend to underperform.

While academics no longer dispute the unusual returns of stocks that split their shares, many will debate the reasons. Here are just three possibilities:

  • Companies split their stocks when the shares become too expensive to entice investors, thus increasing demand for those shares.
  • When management is optimistic about a company’s future profit or cash-flow growth, it signals that confidence via a stock split. Subsequently, profits rise, further driving up the share price.
  • Companies tend to split while stocks are going up, and plenty of other research suggests that stocks rising in price tend to continue rising.

Those last two rationales are self-fulfilling, suggesting that companies already in line for strong stock-price gains are more likely to split their shares. And to that we respond: So what? If you own a stock that splits its shares, just enjoy the ride.

Unfortunately, splits have yet to regain all of their popularity. Apparently, the 2008 market meltdown has more than just investors spooked.

According to Briefing.com, 235 US-traded equities have split their stock at least 11:10 since the start of 2008. In 2005 alone, there were 319 splits.
 
After just 12 in 2009, the number of splits rose in 2010 and 2011. The split count is on pace to decline this year, but even if the trend reverses, we won’t come close to the numbers seen from 2004 through 2007.

Should you buy a stock simply because it announces a split? Of course not, because a split does not guarantee outperformance. But investors should take a positive view of a split announcement—especially if it comes from a stock with strong profit growth potential and solid recent returns over the last year.

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