Why Do Companies Split Their Stock?
Stock splits don't actually change the intrinsic value of a stock, but they do often create euphoria among shareholders and potential buyers that can propel a stock's price sharply higher. Does it make sense that splits can cause such a stir?
A stock split occurs when a company divides a stock's price by a ratio relative to the number of additional shares being issued - say 2-for-1. Regardless of the ratio, the stock price will decline and the quantity of shares outstanding will increase. It's no different than changing two $5 bills for one $10 bill. Two $5's for a $10? Why bother?
Corporate executives know that stock splits are among the most powerful and cost effective marketing tools ever invented. Splits make shareholders feel great and leave them with a sense of greater wealth - all with little expense to the company.
The primary motivation for a company to split its stock is to make the price more attractive to the average retail investor. The reasoning is that more people will want to buy a stock at $50 than $100. To some it just makes more sense to pay the same commission to buy 100 shares of a $50 stock, than just 50 shares of $100 stock. Admittedly this is mostly psychological - but the essence of the entire market IS psychological. Further, as more people buy the stock at the lower price, the stock tends to rise in price. This is called the "split effect" - an important factor in causing the "euphoria" mentioned above.
A key point to keep in mind is that a stock split is typically a consequence of outstanding performance. A company generally wouldn't feel compelled to make their stock price more affordable if the price hadn't already run up to a price level investors consider "too high." Splitters typically are the "movers and shakers" of the securities world. They are the stocks that normally have the fastest growth and strongest momentum on their side.
Another reason a company may want to declare a stock split is to make more shares available to trade. Institutions in particular avoid lower-volume stocks because moving bigger trades in or out of the stock could drastically alter the price. The more shares outstanding the less impact there is on the price of the stock as institutions buy and sell.
Do all stocks that increase in price eventually split? Most do, but there are a few that don't. Berkshire Hathaway class A (BRK/A) is a prime example. BRK/A is currently trading above $125,000 per share...that's one expensive stock!
Though some might think that a stock split is simply an accounting function that has no bearing on the stock value, research shows that stock splits frequently have a positive effect on share prices. The goal for trading stock splits is to capture a portion of the positive price moment that occurs during the stages of a split cycle. A stock split is more than a one-time transaction. It's a powerful progression in value and goodwill that offers excellent opportunities for traders who understand the market impact of these dynamic events.
Supply and Demand
Stock splits present genuine opportunities to make good profits. This isn't a new concept - the RightLine Stock Split strategy has been used successfully for many years.
Looking at a stock split simply as a "two nickels for a dime" independent event misses a significant point. The split isn't just an isolated event; it's a powerful progression in value and a great opportunity to tilt the market scales in our favor.
When a stock is on fire and rising fast, it is always a result of the demand for shares exceeding the supply. Whenever there are more people who wish to own a stock than are willing to sell at a given price, the sellers must be induced to give up their shares. The only way you can get them to sell is to offer a higher price. At some point they surrender to temptation and take the offer.
Sellers and buyers equal supply and demand - the primary reason that stock prices change. Stock splits have proven to increase and intensify demand, resulting in higher prices.
Which Stocks Typically Split?
Splitting stocks commonly possess some similar characteristics. Normally, the stocks of companies that announce splits have been making one new high after another. In many cases they have announced splits in the past. More often than not, several stocks within a sector will announce in a short time period. This is due to the market tendency to rotate in and out of sectors. When a sector is hot, many stocks in the group are setting new highs and therefore have a good reason to split. We refer to stocks that are poised to split as "split candidates."
Again, keep in mind that a stock split is a consequence of strong performance. Stocks that have been declining over a period of time will rarely announce a split. In summary, the typical splitter is growing earnings at a faster rate than its peers, is trading at or near its 52-week highs, and is viewed as a leader in its sector.
Stages Of A Stock Split
Our studies show that the "typical" life cycle of a splitting stock can be dissected into six major categories:
While many stocks will retreat and consolidate for a while, super strong performers sometimes show little sign of Post-Split Depression and continue to fly higher.
The Split Effect Continues . . . A Number of Ways To Profit
Research shows that splitting stocks outperform "non-splitting" stocks for up to three years after the split. Strong stocks tend to stay strong and the cycle begins again.
There is no single best way to trade splits, as the various stages offer specific advantages for different trading styles. Traders who favor the "buy" side of the market may prefer to play the candidates that we introduce during the Pre-Announcement Stage, while others wait for the announcement or Pre-Split Run. Traders who regularly sell-short often wait for the Post-Split Depression stage to kick in before entering.
There is nothing magical about investing or trading in splitters - they are typically strong stocks that afford us a good selection from the universe of stocks available. Splitting stocks are typically superior stocks. Like any market phenomenon, a splitter's performance is in constant flux, yet has defined patterns.
It's always important to consider your expected holding period - time frame - when planning your investment or trading portfolio. We suggest that investors who are looking for exceptional gains zero in on stocks that are likely to split during the next three to six months.
Once a stock split has been announced, make a note to re-evaluate the position on a daily or weekly basis. Depending on the market reaction and the stock's price behavior, it may then be a good time to consider moving into another stock that is likely to split in the next three to six months.
The tips listed below should also be helpful for traders with a shorter time frame who prefer to actively trade their positions.
Ideas That Can Improve The Probability Of Making Profitable Trades
How We Choose the Split Candidates Presented in the RightLine Report
There are numerous companies that have announced, or will soon be announcing splits, yet we only cover those stocks that offer traders the best opportunities to make a profit. We frequently see substandard low volume stocks announce splits; there are several reasons that companies split their stock aside from having appreciated to new highs.
Sometimes a company must announce a split in order to meet the exchange's listing requirements that oblige them to have a certain number of shares outstanding. We exclude these stocks from our list of stocks to cover. Also, we prefer stocks that trade options. For a stock to trade options they too must have a minimum number of shares.
When we cull the weaker players out of the pack, the relative performance of the remaining stocks is much higher. We create a menu of the strongest stocks by focusing on the "cream of the crop."
As we're fond of saying here at RightLine, knowledge is power. Whether you're a short-term or long-term trader, split strategies can provide the basis for profitable trades. Our special list of 100 likely splitters offers a great starting point for finding high quality stocks that fit YOUR trading style. Take advantage of this opportunity and enter the market armed with this valuable, one-of-a-kind Stock Split Report!
For information on the basics of stock split announcements, key dates and split ratios, go to Basics Of Stock Split Announcements.