Amazon announced plans to split its stock last week, and it was only the most recent tech giant to do so: Apple, Tesla, Alphabet, and Nvidia have all split theirs over the last couple of years. There’s a reason for that: stocks tend to significantly outperform the market in the 12 months after a split. But you might not know why – and that’s key to maximizing the opportunity.
Cumulative outperformance of stock splits versus the general market. Source: Nasdaq Economic Research
Most investors believe that stock splits don’t affect the fundamentals of a company, and so they shouldn’t be taken into account when making investment decisions. That makes sense: a stock split simply redistributes shares, without changing the percentage of the company that investors own.
Take Amazon’s proposed 20:1 split. For each $3,000 share you own, you’ll get 20 new ones worth $150 each. Yes, you get more shares – but they’re at a proportionately lower price, so it seems pretty useless. There’s no reason to believe that a split will boost a company’s revenues, profits, or dividends either – so what gives?
Why stock splits bump prices up
Two main theories are generally put forward. The first is that a lower price means more retail investors will be able to buy the shares. Amazon’s shares cost close to $3,000, so if you can’t buy fractional shares through your broker, you probably won’t buy the stock. Options, meanwhile, generally have a multiplier of 100 – where a single call option gives you control of 100 shares. So a stock high price also limits options strategies, further reducing the number of potential participants. By reducing the price of a share, a stock split allows more investors to participate, increasing the demand for the stock and pushing its price up.
The second theory is that a lower price increases the likelihood that the stock will be included in an index. Since some indexes are still based on price (like the Dow Jones Industrial Average ), stocks with a high price are unlikely to be added. A lower price will make a stock more likely to be included, pushing investors anticipating changes in those indexes to buy the stock and driving its price upward.
These two theories are all well and good. But there’s another one that’s lesser known and arguably stronger: a lower price makes trading easier and cheaper, and the stock more valuable. When you look at the cost of trading, three factors are particularly important: how wide the bid-ask spread is (the price at which you can buy and sell), how liquid the stock is, and its volatility. All else equal, a less liquid, more volatile stock with a wider bid-ask spread will be a lot more expensive to trade. And the more expensive it is to trade a stock, the lower its valuation will be – investors care about after cost returns, after all.
Somewhat surprisingly, a stock split significantly improves all three of those factors. According to Nasdaq, a split on average reduced the bid-ask spread by 22%, improved the volume of trading (i.e. liquidity) by 18%, and reduced volatility by 3%. As well as reducing transaction costs, stock splits also directly benefit company valuations by reducing the cost of equity capital. Based on a 2009 study, that cost fell by an average of 17.3%. Cheaper capital means a lower rate by which to discount future cash flows, and a higher valuation. In other words, by improving the tradeability of a stock and reducing the cost of capital, stock splits do have a positive impact on fundamentals – and that explains why a higher valuation (and rising price) is justified.
Why you should care
First, successful investing isn’t all about finding the most exciting opportunities: it’s about paying attention to those little details too – the ones that are often overlooked by other investors. This might seem boring and overly technical, but market microstructures really do matter, and they could significantly improve your long-term returns.
Second, if you understand why an apparent puzzle exists, you’ll be in a better position to recognize when it may or may not appear and to profit from it. By tracking a stock’s improvement in bid-ask spread, volatility, and liquidity after a split, for example, you’ll be able to anticipate whether the split will translate into a higher valuation or not.
Third, you could try and profit directly by predicting which stocks are likely to split next. A good place to start would be stocks with a market capitalization over $10 billion and a high price:
Highly priced large-cap stocks – potential targets for a split. Source: Finviz.com
