Traditionally viewed as a bullish signal, stock splits have established an almost cult following in the States. Often, it seems that the stock price afterwards a split is drawn back towards the original price, regardless of whether there was a split to create more shares or a reverse split (consolidation). Another reason for share prices to rise after a stock split is that demand increases, as more traders see the shares as affordable. A recent example of this is the split in Warren Buffet’s company the ‘B’ shares in Berkshire Hathaway (BRK/B) were split 50 for 1 in early 2010, and many investors seem to have been impressed enough by this buying opportunity to force up demand and push the price up to around $80 each. Berkshire Hathaways other shares, which have never been split, the ‘A’ shares are still beyond the reach of many investors – they have traded up to $140,000 each!
More likely, is that stock splits exaggerate a current stock trend. If the price is reaching a level from which a stock split seems the right thing to do, then it must have enjoyed a prolonged uptrend. So a stock in a strong uptrend that splits its stock from say £30 to £3 for liquidity issues is very likely to re-list at above £3 after the split. However a stock that has reached a plateau and is now performing indifferently is less likely to outperform after the split. Of course stock splits do not in any way change the value of a company, just the public perception.
There are several phases to a stock split, and you need to understand them to know where to trade for the best returns. The most profitable time is before the announcement of the split, and you can only guess at this stage which companies are likely to consider splitting their shares. There are some Internet services and reports that claim to highlight likely candidates, or you can do your own research.
When the announcement comes, the share price often jumps, and may increase over the following days. To capture this move, you need to be quick on the draw. It helps if you have previously shortlisted possible candidates, and are ready to trade accordingly. It’s important to move your stoploss, particularly if you entered the market before the announcement, as many stocks will tend to drift after the initial flush of enthusiasm. It takes a strong stock in a leading market sector to continue the climb.
You will normally see a run-up in price when the date for the split is coming near, and you can play this by keeping an eye on the stock so that you can jump in when you see this short-term trend starting. When the split actually occurs, the price usually climbs quickly. Investors who waited for the stock to split to what seemed an affordable level will now be buying in, increasing demand and pushing the price up.
The final price movement caused by the stock split is often a decline. The excitement of the split tends to make the new stock overbought, and inevitably there is some consolidation later. If you are so minded, it’s quite possible to short sell the shares at this time, and profit from the pullback. This is a relatively low risk strategy after the increased demand has dissipated.
On the other side, human perception being what it is, stocks that have experienced a cataclysmic fall in value will rarely be considered for consolidation. Say Marconi was trading at 7p and consolidated its stock on a 100 to 1 basis and relisted at 700p. The suspicion must exist that the stock would immediately suffer weakness. It’s almost as if the company is preparing for a further fall in value by giving it room to decline. There is psychologically a much bigger gap between 700p and 0p than 7p and 0p. There will always be ready buyers for ‘option’ money!
Note: This example is taken from the past on purpose (not because the article is out-of-date). The example is only provided as an illustration and is not intended to be a tip to buy into the mentioned company.