While a company may split its stock for many reasons, the most prevalent reason is to make the stock price low enough to attract new and smaller investors while at the same time not hurting the existing shareholder base. This usually will allow the stock to continue to rise in price and follow its current upward trend.
Table of contents:
- Introduction
- What are investors asking?
- Is it good if your stocks split?
- Why would you split a stock?
- Do stocks usually go up after a split?
- How do stock splits work?
- Do stock splits require investor approval?
- Do stock splits affect dividends?
- How to Trade stock splits for a profit
- Conclusion
Introduction
Legendary investor and Chairman of Berkshire Hathaway, Warren Buffett doesn’t like stock splits. He believes that not splitting Berkshire Hathaway’s stock ensures that the investors who own shares are long term investors who believe in the company and its mission.
This has resulted in Berkshire’s class A stock hitting prices as high as $500,000 per share. While Mr. Buffet’s stated goal is a noble one, we believe it unfairly penalizes the small investor. Don’t get me wrong, we totally respect Mr. Buffett, but we are extremely happy that not all quality companies believe the way he does. Stock splits can create some very good money-making opportunities for investors. This post attempts to answer some of the questions those investors are asking about stock splits.
What are investors asking:
Imagine this scenario: you buy a stock for $10 per share. The stock begins rising in price and you are getting very excited. After holding it 6 months, the stock’s price has doubled and risen to $20 per share. You continue to hold it because you figure the stock is on a run and will continue to go up in price. Then one day you wake up and check price and you notice a news announcement by the company that says the stock is going to have a 3 for 1 stock split. My god! What does this mean? What should I do? How can this hurt me? How can it help me?
This scenario actually plays out quite often in the market, so we went to Google to find out what people were asking about stock splits and these are some of the questions we found:
Is it good if your stock splits?
The answer to this question is yes, it is good if your stock splits. Generally speaking, when a company splits its stock, it is a sure sign that the company and the stock are both performing well. The usual reason for the split is the stock is trading too high and the price is becoming out of reach of smaller investors. If the company wants its stock to continue to rise, it can’t afford to exclude this group entire group of investors. While these investors only work with small amounts, there is a lot of them, and it adds to a very substantial amount of potential investor capital.
Smaller investors are usually late to the game and by the time they decide to get involved the stock is too high in price for them to afford. Splitting the stock brings the price down to a reasonable level so they can afford to get involved. It just makes sense that a company would only do this when their stock is moving up in price, rather than a stock going down.
Why would you split a stock?
Most companies split their stock in an effort to continue the upward momentum of the stock’s trading price. As a stock continues to go up in price, it becomes harder and harder for smaller investors to buy the stock. This cuts off the flow of a lot of new money and can create a negative drag on the stock. Splitting the stock is a way to stop this from happening. So, the answer to this question is most companies split their stock to keep the price of the stock at a reasonable level so all investors can buy the stock.
Do stocks usually go up after a split?
Yes, stocks usually do go up after a split. In my experience here is how it works: stocks tend to rally into the split (starting at the announcement). Then once the split occurs, the stock tends to sell off as traders often take their profit at this point. The stock usually remains strong and will continue the next wave of upward movement giving nice profits to those who chose to remain in the position after the split. (Tesla example)
How do stock splits work?
A stock split occurs when the board of directors decide to increase the number of shares outstanding while the same time the price of those shares is decreased proportionately. It is usually described in a format like 2 for 1 which would mean that for every 1 share you own you will now own two. If the stock was $100 per share you would now have 2 shares at $50 per share. Stock splits do not affect the market capitalization of the company.
Do stock splits require shareholder approval?
For the most part, only the board of directors must approve the split. Many stock split transactions are accomplished via a stock dividend which does not require shareholder approval. For the most part stock splits are seen as very good thing for a stock and the investors and if a vote was taken, a no vote would be highly unlikely.
Do stock splits affect dividends?
The short answer is that it does, but not much. The amount of each dividend is lowered in direct proportion that the number of shares is increased. This means that the amount of actual dollars you receive in a dividend does not change. If you have 100 shares of a stock at $50 and company pays a 1% dividend you receive $5. If the company splits it shares 2 for 1 you will now have 200 shares at $25 and the dividend will be .5% or $5.
How to trade stock splits for a profit
- Set up a Google alert to be alerted to any announcements of stock splits.
- Enter the position as quickly as possible on the announcement
- Hold the stock through the pre-split period
- Keep holding the stock through the initial pull back from the actual split date
- Sell into the strength of the next move higher
So, here is the strategy for making money on stock splits. You set up a Google alert that becomes your eyes and ears in the market looking for companies that announce they are going to stock their split. To take advantage of this trade you have to move quickly. Buy your position and hold on for the ride. Most splits trade up until the actual split day. Once the stock splits, it will usually experience a minor sell off as traders take their profit. Hold the position through the next rally which usually is at least as high as the high it traded to just after the split announcement. When it breaks the pre-split high, we set a target of 20% above that for our exit point.
Conclusion
In this post we have discussed what stock splits are, why they occur, how they are structured and how we can use them to make money in the market. We also have answered some of the top questions investors have about stock splits. Finally, we have shared a very basic trading strategy to help you take advantage of stock splits when they occur.
Key Takeaways
- Stock splits are good for a company and it’s stock
- Stock splits are a very good sign that a stock is doing very well
- Stock splits usually result in the stock going higher
- Stock splits can help a stock reach higher levels by making it possible for small investors to buy the stock
- Stock splits usually have a predictable price pattern and can offer some good trading opportunities