Investors Behavior Toward Stocks Splits Literature Review

Type of paper: Literature review

Topic: Finance, Stock market, Investment

Pages: 10

Words: 2750

Published: 2019/09/24

A share split is an action taken by corporate executives to increase the number of outstanding shares by dividing each share by a given split ratio that diminishes its price. In this case, the stock market capitalization does not change since the price per share reduces by the ratio of the share split. For instance, if a company splits its shares in the ratio of two shares for each one share held, the share holders will enjoy an increased numbers of shares nut at a reduced price thus the overall market capitalization remains unchanged.

Stock splits are not a new term in world stock exchanges, many company have adopted the policy for a couple of reasons all geared towards increasing the marketability of its shares. Equity bank, for instance, one of the leading micro finance institutions in the world, incorporated in Kenya recently split its shares in a ratio of 10-1 giving the shares a lot of liquidity and marketability.

In finance, investors are said to be rational decision makers and would try to maximize the returns to their investments by whatever means, given several constrains. Their response to share splits thus depends on several factors as explained below.

Information available-financial information is critical in making investment decisions. The amount of information that investors have thus informed their response to proposed share splits.  If investors have adequate advance information concerning the share split, future investment projects by the company among other relevant information. They are likely to respond quickly to share splits.

Nature of investors – there are several types of investors in the stock exchange. The broadest categories of investors in the market are the long term investors and speculators. Long term investors may not quickly respond with the same gusto as the speculators who would want to make a quick kill from the investment opportunity after the shares become more affordable. Usually, such speculators are small investors who do not have enough capital to invest in expensive stocks but prefer the cheap and affordable investments.

Economic situation – although share splits happen in companies that are doing well, investors may be quite skeptical about purchasing stocks if they foresee a gloomy economic future. Investors buy shares if they anticipate a rise in the share prices, with a depressed economic situation, the possible share price increase may be overshadowed.

Reverse split is the opposite of a share split. In some stock markets, there is a required minimum share price. If the companies share prices dip below the required share prices of that particular company, the share holders may be advised to consolidate their share holding, a term referred to as reverse split.

There are several reasons why companies prefer to split their shares. The decision to split share in a company is informed by the behavior of investors towards a share split. This article thus explores the behavior of investors towards a share split and the impacts of the split on the investor’s earnings.

Most traders view a stock split as a very crucial investment opportunity with great potential to increase their wealth. They consider share splits as a positive step in value and good will of the company, share splits thus psychologically makes investors feel wealthier. In some cases, some investors take stock splits as dividends oblivious of the reality in terms of the impact of such splits on price and market capitalization of the company’s shares.

Critics however, argue that stock splits only make since in accounting and are quite irrelevant in real life since they do not affect performance of the shares. They actually think that shareholders would be stupid to believe that their wealth has increased as a result of a stock split (Shiller, Robert 1981), Empirical studies have however confirmed that increased market activity as a following a share split is justified. In 1996, a study by David Ikennbery of Rise University in Hong Kong measuring the long term and short-term effects of a stock split on the performance of the company company’s securities. His research findings indicated that 1275 companies that had split their share between 1975-1990 performed 8% better than their similar counterparts who had not split their shares in the first year and about 16% better in the subsequent three years.

In 2003, the same researcher updated his research but this time included splits of 2-1, 3-1, and 4-1 and found that the results from this study were very similar with his original findings. He found that the companies that had split their share in the ratios above reported better results compared to those stocks that were not split, in the first year following the split and about 12% better than their counterparts in the following three years. In another research carried out in China and published in 2005, although stock splits appear purely cosmetic, there is ample empirical evidence that they are associated with abnormal returns. Theoretically, there are several reasons that explain the behavior of investors in case of a share split. This reason rotate on the fact that a share split increases the number of shares held by the shareholders and at the same time reduces the price of the shares thus making them more affordable.

One, stock splits announcement raises attention to a company’s perceived success. This is because, for a company to split its shares, they must be trading at a price above the market and industry average. Such high prices result from the company’s success leading to high prices for its shares.

If a company is perceived to be successful, investors would like town stocks in that company with the intention of benefiting from the capital gains expected in the long run. Investors thus respond very quickly to the announcement of a share split with the hope of making more money as the share prices go up.

The reduced price per share after this split of the shares often attracts many investors since the smaller investors can now afford to purchase the company’s stocks at the reduced prices. The increased activity at the stock exchange usually makes the company’s prices to increase. Such an increase in the prices of the company stocks is a benefit to the well positioned investors who purchase their stocks at the announcement of the split. Some company’s share prices are very high to the extend that low income earners are not able to afford. With the lowered prices as a result of share splits, many investors will buy stocks at the affordable rates.

Life cycle of a share split

The behavior of investors towards a share split can also be analyzed using the lifecycle of a share split. Investors in the stock market behave differently at the different stages of the life cycle and thus it’s important to understand this lifecycle as an investor. Such an analysis also gives hints on the best time for one to invest in the stock market following a share split.

Pre-announcement

During this stage, there is not much fanfare in the stock market after a long period of healthy growth. In many cases however, emergence into this stage occurs quickly as unexpected gains cause a rapid increase in the prices of the stocks. Significant changes in price are thus witnessed at this stage. To make a good profit during this stage, it’s important that one identifies the stocks that will most likely be split and when they will be split. Investor behavior at this stage is unpredictable since investors do not have perfect information about the split and they only carry on their business as usual although sometimes there are indicators that may lead investors to anticipate such splits such as abnormally high prices per share.

Announcement

The upbeat atmosphere of the share split usually pulls investors in large numbers to buy shares at the reduced prices. The influx of traders in the market leads to an increase in the stock prices and this gives exceptional advantage to those investors who are well positioned before the announcement since they can sell their securities at the increased prices and make capital gains or simply wait and receive higher dividends I the future. For those investors who were initially not in the company, this period usually offers a low risk set up for timing short term trading entries. It is at this time that speculators get in and buy shares only to sell them in the near future immediately the prices look up (Simon, Herbert 1947).

Dormancy period

In this period, there is a return to normalcy in prices and behavior in the weeks following the announcement of the split s the initial interest subsides. The shorter this time interim, the less subdued this stage will be.

Pre split run

For many stocks, this is the most powerful phase of the share split cycle as investors are busy bidding up the prices of the limited stock supply. The prices are still high pending the speculators mass shift from the stock exchange. Shiller, Robert 1981)

Post split run

Here, the investor’s excitement after the share split is begins to fade. This stage is characterized by a retreat in the price of the share as speculators are actively selling their securities in the short run. The increased supply of the securities drives the prices down thus as the speculators exit the market. This is believed to be the best time for the long term investors to buy the securities at the reduced prices and profit fro the capital gains I the future after the prices stabilize.

The above analysis indicates that the behavior of investors towards a share split will depend on the particular stage n the share split life cycle. Investors consider the price of the share and the potential future earnings in making their decisions on investment.

Although practitioners like ( Bakerand Gallagher, (1980; Baker and Powel,1993) suggest that marketability of the stocks is the primary motivation for stock splits, fewer papers have shown interest in this possibility. Academic research on common stocks has however found some support for marketability hypothesis. For instance, (Lamoureux and Poon 1987) and Maloney and Mulherin 1992) confirm that the number of share holders in a company increases following a stock split. A Schultz 1999) shows that the number of small investors increases following a share split and majority of these new investments are new buys.

According to empirical studies, Managers report that the main report that the major factor that contributes to stock split is to move the price of the stocks to a better and desirable trading range. The trading range for most stocks in the United States is 20-35 USD (Baker, Phillips and Powell 1995) in a review article on splits.

Stock splits have been a common feature in the Newyork stock exchange. Of the listed stocks in the market at the end of 1930, almost 20% split at least once in the prior 10 years. Over a half a century later, 5-10% of all the listed companies announced a stock. The stock prices I this stock exchange have been quite stable for quite a long time, averaging between $30 to $40. Over the last half a century, the average Newyork Stock Exchange has stayed in the dollar range despite the remarkable increases in consumer prices and corporate equity values. This constancy in the price levels has been partly attributed to the frequent share splits. Some companies however, such as Berkshire Hathaway and Google, though have very high share prices averaging about 100,000 and 500USD respectively have not had share splits in their history.

Another interpretation of investor behavior is that investors and analysts have no preferred price but simply adapt from the firms past split behaviors. Pilotte and Manuel (1996) for instance, provide evidence that the firms post split earnings performance to make inferences about a newly announced share split. If managers assume an optimal price for the splits and their stocks maintain that particular price level, investors can be seen to infer the manager’s private information based on announced split price and respond to that information. A lot of research a lot has been found to support these claims even if the motivation for that belief is less clear (e.g. Baker and Powell, 1993).

Financial theories advanced to explain stock splits rely primarily on two attributes. The information flows between investors and managers and transaction costs as financial intermediaries and investors interact.

Theories focusing on interactions between investors and intermediaries investigate the idea that share splits adjust prices to a level that redues the transaction costs and at the same time increases the investor trading opportunities. At this level, investors will find the securities to be more attractive and will move in to purchase more shares thus increasing the liquidity of the shares in the stock market.

Summary and conclusion

As mentioned earlier, share splits can also be reversed by the managers of the company. It is done when management intends to place the shares in an attractive range. Decisions to consolidate shares is either discretionary or non discretionary. Management may decide to improve the company’s image by consolidating the company’s shares if they are selling at an abnormally low price. This increases the marketability and demand for the shares. This is because investors’ view too low share prices as being speculative.

Management may also consolidate the company’s shares to attract institutional investors. Such investors make huge share purchases and invest with along term perspective. For management to attract such investors, the share prices must be attractive.

Reducing the number of outstanding shares also has an effect on the earnings per share attributable to the existing share holders. Since earning per share is computed as after tax profit for the company divided by the number of ordinary share holders, reducing the number of ordinary share shares will have a positive impact on the share holder earnings.

In some stock exchange markets however, firms are supposed to maintain a given level of price per share. Incase a firms share price drops below this level required, then the company has no option but to consolidate its shares. This phenomenon is called non-discretionary reverse split.

A lot of research has been directed towards the behavior of investors towards stock splits. Findings from most of the researches’ indicate that there is positive correlation between stock splits and investor response to the markets activities. Empirical research indicates that companies that have split their shares have reported better performance than their counterparts who have not split their shares. Many researchers have backed these findings with empirical evidence that indicate that such companies perform better by over 8% while others dismiss such claims as very cosmetic and baseless. They believe that stock splits do not alter the wealth of the share holders since there is no real change in the market capitalization. They argue that investors are stupid enough to believe that the increased number of shares as a result of a share split improves their wealth. They argue that such believe is not true and only in the investors psychology (Fama, Eugene 1965).

Other researchers on the other hand have proven that the lowered prices after the share split induces small investors to purchase more shares since they become affordable after the share split. The increased attention towards the company after the announcement of the share split by investors leads to the appreciation of the company’s stocks prices. This creates value to the share holders through capital gains or future dividends in the long run.

A lot of opportunities for empirical research however, exist on the benefits of a share split on the companies shares. It’s also important that share holders and investors have clears information on the impacts of the pre and post split effects on their future earning. In making investment decisions after a share split announcement, investors should understand the implications of the share split on the various financial ratios such as the dividend per share, dividend yield, price earning ratio, market price per share amongst other relevant information.

This area presents a good opportunity for researchers to explore all the information pertaining to the share split so that investors can be able to make informed decisions on the timing, impact and magnitude of their investments before and after a share split announcement.

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