Should you invest in a company because it is doing a stock split?
I encourage people to ask me questions about my book, The Confident Investor, or about the stock market, in general. I am open to questions from Twitter or on this site. I recently received a question about stock splits. The basic question asked if it was a good time to buy immediately after a company split its stock. The purist answer is that it shouldn’t matter but that may not be the complete answer.
First, a bit about stock splits. Companies split shares of their stock to try to make those shares more affordable to individual investors. When a company does a stock split, its share price will decrease, but the market capitalization of the company will remain the same. For example, if you own 100 shares of a company that trades at $100 per share and the company declares a two for one (2:1) stock split, you will own a total of 200 shares at $50 per share immediately after the split.
The reason for stock splits has dropped over the years. Before the advent of easy trading brokerages on the Internet, it was not uncommon to see penalties for buying shares in increments other than 100 shares. With this penalty removed, individual investors are free to invest the amount they can afford – $1,000 of a $10 stock (100 shares) is just as easy to buy as if that stock was $25 per share and the individual investor only purchased 40 shares. This is mostly irrelevant to “institutional investors” that may be buying millions of dollars of a stock.
Some companies now avoid stock splits altogether. The theory is that the stock split doesn’t matter so why do it. Also, if the company is catering more to institutional investors rather than individuals, then the higher stock price doesn’t matter. As further benefit, the higher stock price eliminates some trading strategies and effectively encourages longer term holders of a stock. Some companies like to have a higher per share price and almost carry it as a badge of honor – Google [stckqut]GOOG[/stckqut], Apple [stckqut]AAPL[/stckqut] and Berkshire Hathaway (BRK-A) being 3 of the most well known with a high stock price. To be honest, a higher stock price even slows down the effectiveness of my program described in my book, The Confident Investor. If you want to learn more about my methodology, you can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in ebook formats for Nook, Kindle, and iPad.
Now to the original question. Should you expect a bump up after a split. The purist answer is no since there is no additional value or wealth being created with a stock split. However, a study of the performance of 2,750 companies from 1975 to 1990 conducted by Rice University professor David Ikenberry found that shares climbed, on average, about 3.4 percent in the days immediately following a stock split.
I could easily argue that this Rice University study is too old to be relevant in the 21st century. This time frame for the study was during the penalty of non-block size trading. It was also a time frame when trades were measured by eighths (1/8) rather than to the penny as they are now (this change happened in 2001).
Bottom line, there may be a small bump up when a stock splits but the markets are efficient enough that this will only be short term and likely not worth trading.