By JONATHAN CLEMENTS, Staff Reporter of THE WALL STREET JOURNAL, October 3, 2000
Pizza lovers would balk at paying more simply because a pie was cut into eight slices rather than six. But stock-market investors show no such qualms.
At issue are stock splits, which seem like meaningless paper shuffling. In a 2-for-1 split, for instance, shareholders end up with twice as many shares. But each share's claim on the company's dividends and earnings is halved, so shareholders are no better off.
Yet companies regularly split their stocks, often prompting a buying frenzy among small investors. Much ado about nothing? It turns out that stock splits are a mixed blessing for investors. Nonetheless, we're likely to see many more in the years ahead. Here's why:
Thanks for Nothing: If a company announces a stock split, think twice before cheering. The fact is, the split has probably increased the cost of trading the shares.
True, it may not make any difference to the brokerage commission you pay. But the split does affect the so-called bid-ask spread. Every stock has two prices, the asking price at which you can buy and the lower bid price at which you can sell.
Suppose the asking price for a stock is 40 and the bid is 39 7/8, which means the spread is an eighth of a dollar. (This use of fractions will soon disappear, as stock exchanges move toward pricing stocks in pennies. But we will get to that in a moment.)
Now, imagine that the stock splits two for one. What happens? If the spread remains at an eighth, the asking price might now be 20 and the bid 19 7/8. Result? On a $20,000 round-trip trade, you would lose $125 to the bid-ask spread, compared with $62.50 before the split.
In practice, spreads, measured as a percentage of a stock's price, probably wouldn't double after a split, but they might increase 20% or more, according to a study by Paul Schultz, a finance professor at the University of Notre Dame. His study appeared in the February 2000 Journal of Finance.
Mr. Schultz looked at 235 stocks that split over the 12 months ended March 1994. "The percentage spread increased considerably," he says. If a stock splits, "you're going to end up paying more to trade."
So why do companies split their shares? It seems a split offers Wall Street an incentive to both promote the company's stock and maintain a liquid, orderly market for the shares.
"The idea is that stock splits occur to ensure adequate compensation to market makers," says Michel Vetsuypens, a finance professor at Southern Methodist University's Cox School of Business. Thanks to the higher spread, brokerage firms may now make fatter profits when their customers buy and sell the stocks involved.
Actions Speak Louder: While a split can boost trading costs, it's also often followed by a jump in the stock's price. Partly, that may result from the publicity surrounding the split and the greater sponsorship by brokers.
But splits may also be a sign of management's confidence in the company. David Ikenberry and Sundaresh Ramnath, both professors at Rice University's Jones Graduate School of Management, looked at more than 3,000 stock splits over the 10 years through December 1997. They found that, in the year following the announcement of these splits, the stocks outperformed comparable companies by an average of nine percentage points.
"These firms did better than the market was expecting," Mr. Ikenberry says. "One of the reasons that companies have the confidence to split is they don't think their share prices are going to recede."
Does that mean that a split announcement is a buy signal? "I hesitate to jump up and down and tell investors that this is a strategy you should trade on," Mr. Ikenberry says. "I think there's a signal involved here, and investors are not paying as much attention as they should. But one probably shouldn't invest one's entire wealth in a simple strategy like this."
Counting Pennies: While stocks that split may have outperformed historically, the trading opportunity could disappear, as more investors try to exploit it. Moreover, the buy signal may get muddied by a rash of stock splits resulting from decimalization.
Currently, stocks are typically priced in minimum increments of 1/16th, equal to 6.25 cents. But with full decimalization slated to begin no later than April 2001, soon all stocks will be priced in pennies.
That's likely to tighten bid-ask spreads, because the difference between the buy and sell price can now be as little as one penny, rather than 6.25 cents. As a result, market makers will see profits squeezed.
In response, companies may opt to split their stock so that their share prices are below, say, $10, thereby increasing spreads and ensuring that Wall Street has an incentive to promote their stocks.
"My intuition is that over time there will be many more stock splits, reducing the average share price dramatically," says James Angel, a finance professor at Georgetown University. "But it will probably take 10 or 20 years to get there."