Stock split of a company comes with a series of developments, which you as an investor need to keep a tab of. Apart from the affordability in the purchase that stock splits offer, you also need to know the proper rationale behind the split. And in analysing the rationale, you also need to ensure that stock splits fulfill the very motive with which they have been announced. Here is an analysis of things when stock splits occur and why do companies go for stock splits. We also analyse whether stock splits create instant liquidity for companies and what you need to take into account when stock splits happen in order to gain from it.
Why a split?
There are three major theories for why companies go for stock splits. One major theory of splits is the signalling theory of Brennan and Copeland (1988). The theory assumed that managers have private information about the future prospects of their own firm. If a firm with good prospects splits, then its percent spread (bid-ask) will increase temporarily. Eventually, the market will come to perceive the same good information that the managers knew, causing the firm price to rise and the percent spread to return to even.
It states that if a company with average or bad fundamentals splits, then its percent spread will increase permanently. This cost differential allows good firms to signal by splitting and prevents average or bad firms from emulating. The signalling theory predicts that splitting firms should receive positive returns on announcement. The empirical evidence finds a positive abnormal return on a split announcement. An empirical challenge for signalling is that there is no evidence that split firms actually experience a temporary increase in percent effective spread as compared to non-split firms.
Another major theory of splits is the trading range theory of Copeland (1979). The idea is that a split lowers the price, which makes trading more affordable. This leads to an increase in the base of traders in the firm. In turn, this eventually increases the volume of trade, which eventually lowers the percent spread. The empirical evidence finds that split firms experience an increase in the base of traders and an increase in volume.
And splits keep stock prices within an optimal trading range, making it easier for small investors to buy round lots, and result in an increase in the number of shareholders. An empirical challenge for the trading range hypothesis is that there is no evidence that split firms eventually experience a lower percent spread. In other words, there is no evidence that splitting firms receive the predicted long-run liquidity improvement from splitting.
The third major theory of splits is the optimal tick size theory of Angel (1997). The idea is that a split causes an increase in percent spread. This eventually causes more limit orders to be submitted for two reasons. First, some traders will switch from using market orders (which are now more costly) to using limit orders (which are now more profitable). Second, some will be enticed to become pseudo market makers who profit by submitting a limit order on both sides and gaining the spread.
The increase in limit orders will eventually cause the percent spread to crossover and drop below where it would be without the split. The empirical evidence finds that after a split the number of limit orders does increase and the limit order to market order ratio does go up. An empirical challenge for the optimal tick size is that there is no evidence that split firms eventually experience a lower percent spread. Again, there is no evidence that splitting firms receive the predicted long-run liquidity improvement from splitting.
Here are the key observations that you need to be aware of:
Liquidity, volumes, and returns
Split firms initially experience worse liquidity but return to even in 9 to 12 months and then crossover into better liquidity. The worsening of liquidity of split firms is temporary and split firms experience gains in liquidity at longer horizons. Often, the improvement in liquidity is observed 24 months after the split. At the times when market liquidity worsens, companies that have split their shares remain more liquid than those that have not. Hence, investors should book profits before or after the split
It is seen that returns on the stock increases after the announcement and there is a decrease in liquidity post-split. It is also seen that the number of quotations and the number of trades increase significantly after stock splits, while the trade sizes decrease significantly and there is no significant change on the daily trading volume. This happens due to increase in the number of shares in a single lot, which are available at a lower price. And this results into trimming down in the number of trades.
The bid-ask spread
The bid-ask spreads that increase after stock splits are more likely to be motivated by an information story and which is the fact that analysts’ EPS forecasts increase by a small percentage. This finding is further supported by the fact that the good returns around the declaration date of a stock split are explained by the information environment of the stock. And it is seen that bid-ask spreads decrease significantly after stock splits.