Stock Splits are Secretly Pumping the Stock Market

Stock splits, they're supposed to be totally irrelevant, right? They don't change anything about the company, they don't change anything about the valuation, they don't change anything about the investing thesis. Well, bizarrely, stock splits are somehow quickly becoming the secret source to making big gains in the stock market.

On the 10th of June, Nvidia did a 10-for-one stock split and rocketed up 11% in the next week of trading. But that's only one example. Tesla did a 5-for-one stock split in August 2020, which saw the stock rise approximately 80% across the next few months. Nvidia did a 4-for-one stock split back in 2021 and saw a 60% rise soon after. Google did a massive 20-for-one stock split in July 2022 and saw a 133% rise in the weeks following.

Now, it doesn't always happen, but it seems that for these big Tech behemoths, more and more stock splits are becoming the secret formula to boosting stock market returns. But why? Well, firstly, a very, very quick explainer: a stock split is simply a measure companies take to bring down their share price without affecting anyone's investment. For example, if a company has a share price of $100 and they announce a 10-for-one stock split, it means that after the split, each shareholder will now own 10 shares for every one share they owned before. The share price will then adjust, so each share, instead of being worth $100, is now worth $10.

Now, companies don't have to do this, as is evidenced by Berkshire Hathaway Class A shares, which are currently around $620,000 each. But there are a few reasons companies will tend to do a stock split. One, a company will opt to split its stock to keep the share price manageable for all investors to be able to purchase one whole share, even though this is becoming less and less relevant these days with many brokers now offering fractional share trading. Two, stock splits can also boost liquidity, which is the amount of shares changing hands each day, so companies with higher liquidity can be more freely traded without fears of affecting the share price.

And three, the main reason why a company may split their stock is to make it easier for their employees to participate in stock purchase plans. Because, as you can imagine, if an employee is putting some of their salary towards stock ownership, it's going to take a while before they can buy a share at say $1,000 versus $100. So, lower share prices make it easier for those stock plans to work.

But while these are all valid reasons for a company to do a stock split, they don't necessarily explain why stock splits more recently have been leading to such massive share price gains in the world's most notable companies. So, I dug deep to try and figure out why this has been happening, and there are a few theories out there.

For example, enhancing liquidity can be a reason to do a stock split, but it can also cause the share price to rise. So, by lowering the stock price and improving accessibility of the shares for all investors, this can spur an increase in buying volume, which pushes share prices higher. A study from 2002 found that following a stock split, there will likely be an increase in volatility from this newfound liquidity. But while that could be positive, it could also be negative, because while the volatility could work to increase the share price, volatility could also see the share price fall.

So, there's also an argument of an optimal trading range for stocks. Research done in the 1980s suggested that firms tend to split their stock to get their share price within an optimal trading range, where both individual and institutional investors find the stock affordable. So, just like what we were talking about before, it makes sense that if you can hit this optimal trading range, then this is the point where your potential shareholder base will be at its highest. This ensures you aren't leaving behind potential investors that want to buy the stock but simply can't.

Now again, this was a great hypothesis for the '80s, but as I said before, it doesn't really hold up too well today, with so many brokers these days just offering fractional share trading options to circumvent this issue. So, while an increase in both accessibility and liquidity may lead to higher stock prices post-split, the evidence isn't overwhelming.

But there is one factor that I haven't even touched on yet that is almost certainly a contributor to these amazing post-split returns we're seeing in 2024, and that is psychology. Across the short term, investor sentiment is everything in financial markets. Remember the famous Buffet quote: "In the short term, the stock market's a voting machine; in the long run, it's a weighing machine." This essentially means that across the short term, stock prices just move in the direction of investor sentiment.

But in the long run, share price performance always comes back to the results of the business. For example, in 2008, a lot of America's companies were actually doing fine, yet because the investor sentiment was so negative across the board, share prices went down. If you grew your earnings by 50% in 2008, oh bad luck, your share price probably still tanked.

Right now, if we look at the S&P 500, share prices are absolutely roaring on the back of positive investor sentiment around AI, led by just seven companies. But if you take out just those seven tech behemoths, earnings of the other 493 companies are, on balance, falling. So, the stock market is all about psychology, and CEOs know that. That's why we see more IPOs when stock prices are soaring. When stock markets are rocketing up, more companies will try an IPO or raise capital, as they have a better shot at tapping into investor euphoria.

Thus, enabling them to eke out a higher IPO valuation, which means they can raise more money while selling the same amount of shares. And this same concept applies to stock splits. It's called the signaling hypothesis, and what it explains is that stock splits are more likely to lead to share price gains because it's seen by investors as a positive signal from management that the company's performance is going to keep improving, and the stock price is going to keep going up.

This effect was noted in a study back in 1990, but it can work in two ways. Stock splits can persuade investors that earnings are likely on the way up, and that causes them to buy the shares, causing price rises. Or it could actually just be that the companies tend to split their stock in economic boom times when they actually do think their upcoming business performance is going to lead to an even higher share price.

For example, Nvidia's current performance is very strong. Apple in 2020 was seeing great performance. Tesla was performing very well a few years back when they did their stock split, as was Google. So, the research shows two things: that companies tend to split their stock when they can see internally that their upcoming business performance will be strong; thus, they need to drop their share price to more accessible levels.

But beyond that, that can also act as a signal to investors to buy the stock, which also causes share price rises. It's similar to how we look at insider buying and selling, right? As Peter Lynch says, there's only one reason an insider buys shares in their own company: it's because they expect the business, and thus the share price, to perform very well over the not-too-distant future.

And because this is true, what we see these days is insider buying used as a positive signal for investors to buy a stock. So, it's the exact same thing with stock splits. They might indicate strong upcoming business performance, which leads to the stock price rising higher, or they might just be a signal to investors that causes them to buy more shares, which in turn raises the share price even higher.

So, that's the main reason that stock splits tend to raise stock prices. And similar to the number of IPOs falling in tough economic times, we can also see that stock splits fall in tough times. Data collected for the period of 2004 through 2011 show that the number of stock splits dropped from 336 during 2004 to 2007 to just 80 during 2008 to 2011. Is this a result of share prices falling and stock splits being less necessary, or is it a result of CEOs not being able to tap into that positive investor sentiment? Well, it might be a bit of both.

But beyond these signaling factors, there are a few more psychological hypotheses foreseeing increased stock returns after stock splits. None as big as the signaling hypothesis we just went through but a few more that deserve to be mentioned just to round out this video. For example, another psychological hypothesis behind share price appreciation post-stock split is the investor attention hypothesis. This hypothesis argues that stock splits can often draw attention from the media and investors, which then increases visibility and interest in the stock.

For example, you probably saw Nvidia make the news recently specifically because of their recent stock split. So, this hypothesis argues that because the stock split caused the company to get more media attention, this media attention likely led to more investors hearing about it, considering it as a stock to own, and ultimately buying it.

And then, beyond the investor attention hypothesis, stock splits can also be looked through the lens of Behavioral Finance. So, the Behavioral Finance theory of stock splits argues something much more irrational: simply that because a stock price looks smaller after a stock split, this has a psychological effect on making the stock look more affordable to your subconscious, when really it isn't.

In the same way that a $900 stock going up to $1,000 seems like a bigger deal than, say, a $9 stock going to $10. We all know that that's the same relative change, but because of the large difference in absolute values, the $1,000 stock looks more expensive than the one that's $10.

So, there are a lot of different hypotheses that suggest why we tend to see share prices rise after a stock split. And I was interested to learn that this isn't even a recent thing. Seminal evidence on efficient market theory sure will give them a mask for that, but that evidence actually found that there were abnormal positive returns around the announcement of stock splits, and that was back in 1969.

So, very interesting that the trend is still holding up today. But that, of course, leads me to my usual disclaimer: should you buy a stock because management just announced a stock split? And, of course, the answer to that is no. While stock splits can lead to positive returns, this is not assured, and there are still plenty of examples of companies' share prices falling after a split.

While Nvidia's recent stock split caused a surge of buying, well, that's currently reversing. Back in 2021, they did another stock split which was met with initial share price rises, only to fall back down a few months later. Also, back in August 2020, Apple did a 4-for-one stock split and saw the stock struggle across the next month. Tesla did a three-for-one stock split on the 25th of August 2022, and despite the news being met with positivity for the first week or two, in the following months, the stock fell horribly as they battled market volatility, supply chain issues, and broader concerns over economic conditions and valuation pressures.

So, it is worth noting that economic conditions and business performance definitely trump whether or not a given business is doing a stock split. As a long-term investor, you wouldn't make a stock split the center of your investing thesis. So, like a lot of these things, stock splits just become a tool that we can use alongside others to help inform our opinions about a stock. Tools which all help to create a complete picture of our investing thesis.

It's kind of like how we don't just value shares by using the price-to-earnings ratio. We consider the PE ratio, but we consider it alongside many other metrics to help give us the most complete picture. And just as a quick plug, if you do want to learn the full start-to-finish investing approach, including reading financial statements, running three valuation methods, and a whole lot more, definitely check out Introduction to Stock Analysis over on New Money Education. Plus, you can now use the code SAVE50 for a sweet $50 discount.

But with that said, guys, that is the lowdown on stock splits and why they seem to be leading to outsized returns of late. Please like the video if you did enjoy it. Please subscribe if you haven't done so already. But with that said, I'll see you guys in the next video. [Music] [Music]