Do stock splits mean anything?

The short answer:  in the US, no; elsewhere, probably.

What a stock split is

In a stock split, a company issues new shares to existing shareholders, in proportion to their pre-split holdings.  In a two-for-one split, for example, each holder of one share receives one new share, so that he then holds two.  His ownership interest in the company is unchanged, however.  The value of his share total remains unchanged, as well.  In the case we are talking about, on the day the stock begins trading ex the split, it typically opens at roughly half the price of the pre-split stock.  (A stock dividend is basically the same as a split, although the terminology and the bookkeeping may be a little different.)

In the US…

Why does a company declare a stock split, then?  Individual investors in the US typically prefer to hold at least a round lot (usually 100 shares) of a stock rather than an odd number of shares.  There’s no economic reason for this behavior. A generation ago, the commissions on odd lots were higher than on round lots, but that difference is long gone.  Still, for whatever reason, individuals would prefer to own 100 shares of a $35 stock than 35 shares of a $100 stock.

Companies like to have individual shareholders on their books because they tend to be loyal users of the company’s products and to be very supportive of company management.  As a result, fast-growing companies routinely declare a stock split when their stock price reaches a certain threshold, maybe a three-for two split whenever the stock reaches $60.  Each time a holder of 100 shares of a $60 stock becomes a holder of 150 shares of a $40 stock overnight.  The main purpose of the move is to make a round lot more affordable to new shareholders, and for additional purchases by existing shareholders.

A stock split in the US, then, contains almost no information about company prospects.  One might argue that the management wouldn’t do this if it expected the stock price to go down, but I’m not sure whether that’s information.  Some academic research points out that stocks tend to underperform in the period after a stock split is paid.  But that’s a bit misleading.  The right interval to consider should begin with the announcement of the split, or, in the case of a company that routinely splits its stock at a certain price, with the time the stock reaches the area where splits have occurred before–and the market beings to anticipate a new split.

Sometimes, stocks “run”, that is, go up significantly, on the announcement of a split.  In my experience, this is almost always a sign of a very speculative market, since the split itself is pretty much meaningless.  But this activity did occur over several years during the internet boom.  We’ll have to see if it resurfaces during the upcoming bull market.

Outside the US…

Outside the US, the situation is quite different.

In Japan, for example, when a company declares a stock split, say 11-for-10, which will reduce the price of a share of stock by 9%, it is asserting that it will be able to show enough profit growth in the year ahead to push the price back to its previous level.

In Australia, companies most often pay the same dividend on each of the post-split shares as it did on the pre-split ones.  In other words, an 11-for-10 stock split would mean a 10% increase in the dividend.  Since dividends are supposed to be paid from profits, this amounts to an implicit forecast of increasing earnings.

In some countries, there may be tax reasons for making a stock split.  Cash dividends may be taxed at a very high rate, so that paying them makes little sense (except to the government).  Or it may be that the entire cost basis may remain with the old shares, lowering the capital gains tax (if any) the holder has to pay if he decides to realize some cash from his investment.

How do you find out the local lay of the land?  Ask an experienced local investor.

Reverse splits—not good

One type of split is universally a bad thing, however–a reverse split.  Invariably this happens when a company with operating difficulties sees its stock price fall below the minimum, say, $5 a share, required to maintain its listing with its stock exchange.  One way the company can, at least temporarily, fix the problem is to declare a reverse split.  As the name implies, in a one-for-ten reverse split, ten old shares become one new share.

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