There are many corporate actions a board of directors can take that affect its stock: mergers, spin-offs, dividends, and, of course, splits. We present a stock split trading strategy and its performance.
Research shows that a stock split trading strategy performs better than buy and hold, contrary to the efficient market hypothesis.
A stock split is a corporate action in which a company increases the number of its outstanding shares while proportionally decreasing the share price, typically to make its stock more affordable and enhance liquidity.
In this article, we are going to look at what a stock split is, how they work and backtest their performance over the years.
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What is a stock split, and how does it work?
A stock split is a corporate action in which a company divides its existing shares into multiple new shares.
The primary goal of a stock split is to increase the number of outstanding shares while reducing the price per share. This does not change the overall market capitalization or the total value of the company.
Stock splits are typically implemented to make the company’s shares more affordable to a broader range of investors and to improve liquidity in the stock.
Here’s how a stock split typically works:
- Effective Date: On the designated effective date, the split becomes official, and existing shareholders receive additional shares for each share they already own according to the predetermined ratio. For example, in a 2-for-1 stock split, shareholders would receive two new shares for every one old share they held.
- Adjusted Stock Price: After the split, the stock’s market price is adjusted accordingly. If it was trading at $100 per share before a 2-for-1 split, it would likely start trading at around $50 per share after the split.
Stock splits are often seen as a positive sign by investors, as they can make shares more affordable for smaller investors and increase the liquidity of the stock.
However, the fundamental value of the company remains the same. Stock splits are different from reverse stock splits, where a company reduces the number of shares outstanding and increases the price per share, typically done to meet listing requirements or boost a low stock price.
Warren Buffett has refused to split Berkshire Hathaway’s A-shares, and today, one share costs more than 500,000 dollars!
Stock splits performance and backtest
In a paper called Long-Run Common Stock Returns Following Stock Splits and Reverse Splits Hamang Desei and Prem Jain explore the performance of stocks following a split and reverse split announcement.
They examined the 1- and 3-year performance of common stocks following 5596 splits and 76 reverse splits made during 1976-91.
For stock splits, they found that, on average, the 1 and 3 year buy and hold abnormal returns after the announcement month are 7.05% and 11.87%, respectively. For reverse splits, the corresponding abnormal returns are -10.76% and -33.90%.
There is another piece of research by Schaeffer’s Investment Research called How Stocks Tend to Perform After Stock Splits where they tested how stocks that split their shares performed after 2 weeks, 1-month, 3-month, and 6-month periods. Here is what they found:
Source: How Stocks Tend To Perform After Stock Splits, Schaeffer Research.
Stocks that split their shares returned on average 5.25% after the split vs 4.39% for the S&P 500. However, only 50.8% of the stocks beat the index.
Lastly, another backtest conducted by Stocksoft Research called How Do Stocks Perform After Stock Splits? also found that stocks undergoing splits have outperformed their peers since 1990:
Source: How Do Stocks Perform After Stock Splits? – Stocksoft Research
They discovered that stock that split their shares returns 11.7% after 180 days vs 9.08% for the S&P 500.
Stock split trading strategy – conclusion
To sum up, today, you learned what a stock split is, how it works, and how stock splits perform. We found extensive evidence that stocks that split their shares tend to outperform their benchmarks. Traders can use this positive drift to their advantage and incorporate it into their trading systems.