Today, we’re talking about a stock split. A market event that on its face, looks like nothing.
It doesn’t affect a company’s overall value. It doesn’t affect their bottom line immediately.
This is a company strategy that can strike fear or excitement in the hearts of investors (depending on the day!).
But if you play your cards right, you can benefit greatly.
What is a stock split?
All publicly traded companies have a set number of shares that are outstanding.
A stock split is a decision by a company's board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders.
For example, in a 2-for-1 stock split, an additional share is given for each share held by a shareholder. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after a 2-for-1 split.
And if the shareholder had 200 shares of the stock before the split, they will own 400 shares of the stock after the split.
Not all stock splits are a 2-to-1 ratio. Companies get creative with their splits depending on their reasoning behind splitting.
According to the Motley Fool, the most common split techniques are 2-for-1, 3-for-2, and 3-for-1.
Apple famously did a 7-to-1 split in 2014.
Imagine waking up and owning seven times the original amount of stock you had purchased in a company.
Because of course that’s how it worked out for shareholders—their share of the Apple pie got a lot bigger.
That was also the fourth time Apple had split the stock in its history!
Now, this shouldn’t be confused with a reverse split.
This is the exact opposite, i.e. when a company essentially reduces the number of stock they have on offer.
Citigroup did this in 2011. They had 29 billion shares owned by people out in the world! But they reduced it by a factor of ten, making it so there were only 2.9 billion out there.
Why would Citigroup do this?
To raise the price of the stock, of course!
But that doesn’t mean that companies that split their stock aren’t also thinking about the price.
Research shows a positive effect on stock price after a split.
To clarify: Yes, a stock split does lower the price of an individual stock.
The company is still worth the same amount of money (market capitalization) overall.
If you owned a share of a stock pre-split with a price of $5, post-split you would own two shares worth $2.50. The stocks are still drawing from the same pool of money.
But the act of splitting a stock (thus making it more affordable) often leads to an increase in demand.
Increasing demand through the split can lead to very favorable increases in price.
Think of it this way: If a brand of milk at your grocery store was suddenly 50 percent cheaper, there would be a rush on that milk.
Everyone would want to buy that milk! Chances are, it may be sold out at the end of that sale day.
Now imagine that same demand for the 50 percent off milk, if the price of the milk changed according to the demand. The price would go way up!
That’s typically how stock splits tend to work out. Both Apple and RIM have experienced huge growth thanks to stock splits—RIM, in particular, experienced a value increase of 73 percent!
My stock split experiences
I first learned about stock splits and the powerful effect they can have on a stock back in 1994.
I typically don't trade the stocks when a stock split is announced.
Instead I trade stock options.
I made a TON of money back in October 1997 on Unilever when they did a 4-for-1 stock split and I made several profitable trades throughout the late '90's and early 2000's.
And then I stopped because I got heavy into real estate.
Last summer, I decided to take a look at my stock split strategy again to see if it still worked.
Since August 2017, I've made 10 option trades using my stock split strategy and so far am averaging an 85% win rate.
Here are my results:
- 3 of the trades are still open with an unrealized gain of 21.72% so far.
- 1 of the trades resulted in a loss of $460. ( I deliberately broke all my trading rules to give the strategy a hard test. Lesson: Stick to the trading rules!)
- 6 of the trades are closed with a realized gain of 61.98% and profit of $3,929.00. (That's an average of $655 in profit per trade!)
Why do stock splits happen?
Every company has different goals when it comes to stock.
Not everyone wants to be Berkshire Hathaway with prices over $100,000 per share. If they get too expensive, the share price becomes too high for most retail (individual) investors to buy.
A company may choose to split their stock so they can keep attracting new investors.
Keeping the stock fluid and continuing growth looks very good to people looking to invest.
A 1996 study by David Ikenberry of Rice University measured the short and long-term performance of stock splits.
His research included all the 1,275 companies whose stock split 2-for-1 between 1975 and 1990.
Ikenberry compared the split stocks to a control group of stocks for similar-sized companies in similar sectors that had not split.
His results were startling. The split stock group performed 8% better than the control group after one year, and 16% better after three years.
In August 2003, Ikenberry – now Chairman of the Finance Department at the University of Illinois at Urbana-Champaign, updated the stock split study.
This time he looked at companies from 1990 to 1997.
Using a similar methodology that included 2-for-1, 3-for-1 and 4-for-1 stock splits, he found the results were essentially the same.
Shares of split stocks on average outperformed the market by 8% the following year and 12% over the next three years.
I conducted my own research study because… of course I did.
I looked at companies from 2010 to 2015.
Shares of split stocks on average outperformed the market by 11.61% the following year.
Stock splits can seem like no big deal. But they’re anything but.
Overall, a stock split is a grand gesture on behalf of a company to take more control of their stock prices.
It’s a sign that they care about their long-term financial prospects.
Most of the time, a company wants to look approachable to people looking to invest.
If you can’t easily afford to put your money into a company, you won’t.
And then what happens when the company has a sudden downturn? There’s no one left to invest in them.
Splitting stocks is often portrayed as a company taking charge of their own financial image.
It’s a powerful move.
By getting in on a stock split (or by sticking with a company after they go through one), you can set yourself up to profit heavily from a major company’s actions.
Now, let's all cross our fingers that Amazon will soon split their shares!