Stock prices are drifting higher due to a lack of stock splits.
Research shows that this is not normal. In fact, back in 2009 an academic study found that U.S. firms had kept their share prices constant at around $35 from the Great Depression through 2009 – that’s 80 years!
But what really interested us was other research showing that stocks that split tend to outperform the market. But since some of that research is now dated, we decided to see if that still holds true today– with new data. What we found was (still) a compelling case for stock splits.
1. Stock splits boost valuations
We looked at all the large cap stock splits from 2012 to 2018. We tracked the market-adjusted performance of each stock before and after the split announcement. The results in Chart 1 shows:
- Just announcing a stock split gave an average boost of 2.5% to a stock.
- That boost added to an average stock outperformance of almost 5% after one year.
That’s significant for existing investors, as each $100 billion of market cap could add $5 billion to the wealth of their investors.
Chart 1: Stocks doing splits outperform the market, typically as early as the announcement of a split
Sources: Nasdaq Economic Research, FactSet, Bloomberg (data shows 56 S&P500 stocks that have split from 2012 through 2018)
In fact, that result held with large cap splits from the last 20 years. However for the analysis below, we’ve kept all our charts to the 2012 to 2018 period, where better spread and trading data is available.
2. Stock splits reduce companies’ capital costs
The interesting question is why something as simple as a stock splits would boost valuations?
The answer seems to be related to lowering trading costs, which in turn improves investors’ returns, which gets quickly priced into the valuation of the stock.
We’ve already shown that stocks with prices that are too high (or too low) have spreads that are wider than similar stocks.
Wider spreads are well known to translate into costs to investors. That’s because a buyer often needs to pay the offer to acquire stock, but later need to sell at the bid to reduce their position. The difference between the bid and offer is the spread—and the larger that is, the more it eats into the returns the investor earned for holding the stock.
Consequently, if trading costs can be lowered, an investor will increase their “after trade” returns.
However the market is efficient, so it follows that if the market sees costs fall, they will actually re-rate the stock upward so that the “expected returns retained after trading” are again in line with other stocks in the market.
Chart 2: Efficient markets account for lower trading costs by boosting valuations
Source: Nasdaq Economic Research
In fact, academic research in 2009 found that liquidity improvements following stock splits reduced average companies cost of equity capital by 17.3%, or 2.42 percentage points per annum, providing a non-trivial economic benefit to corporates and investors.
We found similar improvements to liquidity and tradability in our own stock split study. In fact we found that on average:
- Spreads improved by 23%, despite the tick size getting larger, thanks to increased competition at the NBBO.
- Liquidity (measured as value traded) increased 14%.
- Intraday volatility reduced 5%.
We also found that close-to-close volatility increased 15%. That’s consistent with many academic studies, but also unexpected given all the other results. In fact it’s so unexpected that many academic studies have tried to work out why this happens pretty consistently. Despite that, they have overwhelming failed to identify the cause.
However that might not matter as much as you think in today’s electronic markets. Trading and quoting in many stocks happens on a second or millisecond basis, so the volatility intraday is much more important to a market maker or algorithm trying to work an order.
Chart 3: Tradability metrics mostly improve, leading to lower costs
Sources: Nasdaq Economic Research, FactSet
You may wonder why we focus on these three factors: spreads, liquidity and volatility.
There is established literature and models that measure what causes market impact. Overall, these models isolate these three factors as the primary drivers explaining trading costs. There is also a sizable TCA industry that continually measures real trading costs using actual trading data. Although their research shows that impact costs have been falling for decades, that cost reduction is also explained by spreads falling and liquidity increasing market-wide. In addition, even current breakdowns like ITGs estimates show that trading costs increase as stocks get smaller; not surprisingly they are also stocks with wider spreads, less liquidity and more volatility
3. Stock splits help investors, customers and staff
A common managerial technique says that that issuing stock to staff helps align them with the interests of the company. However, high priced stocks don’t maximize the wealth of staff and customers for a few reasons. Those who:
- Hold stock are also penalized by the 5% liquidity discount on high-priced stocks. Every $100 million of staff stock holdings could be worth $5 million more.
- Sell stock are also crossing wider spreads, receiving less value from their sales. For example, a stock with a spread of 10bps will cost $50,000 for every $100 million of sales each trade (assuming each trade crosses a half spread). Reducing spread to 2bps would reduce spread costs to $10,000.
- Are Issued stock: will receive less stock than intended, and possibly no stock, thanks to the fact that stock cannot be issued in fractional shares (Chart 4).
- Don’t hold round lots (being 100 shares): will find that the market rules make it harder and more expensive to trade for a few reasons. Odd lots are not protected, nor are the best odd-lot bid or offer prices shown to investors. Consequently, the smallest staff holders might find the market less transparent and even more expensive to trade than necessary.
Chart 4: Shares issued on a stock priced at $1000 /share (by bonus size, after tax)
Source: Nasdaq Economic Research
Because of the need to cover taxes first, even a $100,000 bonus is paid as an “odd lot,” which are harder for staff to sell at the best market prices.
There are other reasons stocks splitting to more consistent price levels works better in today’s market too.
- Institutional commissions are still in cents-per-share, so very high stock prices distort who pays for broker research.
- Liquidity incentives (rebates) are also in fractions of a cent-per-share, making it harder for exchanges to improve market quality in high priced names.
In short, a perfect stock price is better for everyone: traders, investors and issuers. At least that’s what the data shows.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.