Slice and Serve: What Is a Stock Split & Why Do Stocks Split?

Slice and Serve: What Is a Stock Split & Why Do Stocks Split?

Key Takeaways

    A stock split changes the number of outstanding shares, and the price per share adjusts itself accordingly

    Though the underlying fundamentals of the company don’t change, there are data points showing post-split outperformance

    Though a stock split isn’t reason alone to invest, some active traders look for pre-and post-split price patterns 

A guy walks into a pizza parlor and orders a large supreme; hold the anchovies. The clerk asks, “Would you like it cut into four or eight slices?”

“Better make it four,” he replies. “I could never eat eight slices of pizza.”   

If you get the joke, you understand the basics of a stock split. 

What is a Stock Split?

Take that pile of stock in front of you and double it, or triple the number of shares—heck, let’s get a little crazy and multiply it times 10. That’s essentially what happens when a company splits its shares. You have more shares than you had before, but are you actually richer or otherwise better off? The short answer: Not on the surface.

In a two-for-one split, one common scenario, investors receive one additional share for each share they already own. The stock price is halved—$50 becomes $25, for example—and the number of shares outstanding doubles.

Otherwise, not much else changes—the company’s market capitalization—that’s the total value of all outstanding shares—and other key financial metrics remain the same. Market professionals have long debated the merits of splits and whether investors realize any benefit, a narrative amplified recently by soaring prices of FAANG stocks and other high-profile technology shares.

Why Do Stocks Split?

Why do companies split shares? Psychology, for one. As a stock price climbs, some investors, particularly smaller ones, may view the shares as too expensive and out of reach. A split, in theory, takes the price down to what may be a more attractive or accessible level, while also feeding a notion among existing shareholders that they have “more” than they did before.

Stock Split Mechanics

Stock splits can take many forms, although the most common are the 2-for-1 split, the 3-for-1 split and the and 3-for-2 split.

A company’s management and its board must approve a split, then publicly announce their intention to do so; the actual split usually takes place within a few days or weeks.

If you’re an investor in a company that does a 2-for-1 stock split, you’ll receive one additional share for each share you already own, likely deposited directly into your brokerage account (because the stock price is split accordingly, the value of your stake won’t really change due to the physical split alone).

Less common is the reverse stock split, in which a corporation reduces the number of outstanding shares, often in an attempt to prop up a sagging stock price. 

Splits allow people to buy more shares. When investors believe they can buy more shares at a lower price, they seem to perceive that as some kind of a ‘deal’ for the stock, even though the value hasn’t really changed.

Splits often pick up during strong periods for the broader market, as was the case in the ’90s and, more recently, in the bull market that began after the  financial crisis in 2008-09.  

But not all companies play the split game. Warren Buffett, for example, has been quite vocal over the years about the folly of splits, stating quite plainly that his company, Berkshire Hathaway (BRK/A), will never split. Shares of BRK/A trade for about about $290,000 apiece as of July 2020. Similarly, shares of Amazon (AMZN) and Google parent Alphabet (GOOGL) have appreciated significantly in the last decade and, as of July 2020, trade for about $3,100 and $1,500 per share, respectively. 

Apple (AAPL), however, has split its shares four times since going public in 1980 and announced on its July 2020 earnings call that it will split a fifth time. The company will do a 4-for-1 split as its shares crossed the $400 mark.

Fuel For Bulls?

While it’s true that a split doesn’t change the fundamental value of a company, there’s evidence that a split may present a bona fide “buy” signal. For example, for the 15-year period from 1990 to 2015, stocks averaged a return of 21% during the 12 months following a split, against an average gain of 8.9% for the S&P 500, according to S&P Dow Jones Indices. 

Trading and Investing Around a Stock Split

For investors, seizing on a split as the deciding factor in whether to buy a stock is inadvisable. For traders, potential benefits of any split-related strategies have grown murkier. Years ago, it was common to buy shares after a split because the stock tended to rise toward the pre-split price within a year. More recently, it’s unclear if that phenomenon still holds true.

There was also the “Chuck Woolery strategy.” Much like the ’80s dating show and its amiable host, what was once ubiquitous now seems of a distant era. Under this tack, you’d buy a stock about two weeks prior to the announced date of a split, then sell it about two days ahead of the actual split—the “Two and Two” trade, to echo Woolery’s commercial break signoff phrase.

The stock tended to rally into the split, then sell off after the split. The effect was especially pronounced during the dot-com bubble. But, like many short-term trades or arbitrage opportunities, patterns changed.

Traders had created a self-fulfilling prophecy, but investors are savvier today than they were in the ’90s and early 2000s. They realize the value of the trade isn’t changed through a split, so the excitement over splits isn’t there.

In other words, that 16-inch pizza, no matter how many slices it’s divided into, is still a 16-inch pizza.

Slice and Serve: What Is a Stock Split & Why Do Stocks Split?

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