Publicly traded companies can choose to split their stock at any time. With a stock split, each existing share is divided into two or more shares. The share price is adjusted accordingly too, so this doesn't actually change the total value of a company.
A lot of retail investors can be confused by stock splits. Should you buy or sell stocks that are going to split in the near future? What is the best time to profit from these trades and should this be a part of your normal investing strategy? I've put this guide together to help you figure out the answers to these questions and more about stock splits.
What is a Stock Split?
The main purpose of a stock split seems to be to target investors and possibly specifically retail investors. A company that has a $1,000 share price may find that less people buy their stock simply because a single share is out of reach for their investing budget. If the company plans a 5:1 stock split, each existing share will be split into 5 new shares. The price per share would be reduced down to $200 in that example.
Even if you could afford a $1,000 share, that might cause your portfolio to be less diversified. You don't want too large of a percentage of your entire portfolio to be holdings in a single company. Splitting the shares allows more people to buy the stock while still keeping their portfolios balanced.
There can be some psychology involved with stock splits too. Someone that only owns one share of a company may be intrigued at the potential to multiply their shares. Even though the amount of money is the same, it simply feels like you have more. This can cause some less experienced investors to buy and/or sell the stock when a split is announced and when the split actually takes place.
Do All Companies Split Their Stock?
It's also important to note that not all companies split their stock. It's a completely voluntary decision left up to the board members for each company. After a strong bull market period when share prices have rapidly increased, it can be fairly common for a handful of larger companies to announce a stock split. This seems to be mostly aimed at trying to continue the bull run by keeping the stock attractive to retail investors.
Some companies will split their shares more often than others. Tesla has only split stock once so far, although a second split in the near future seems possible. Amazon has split their shares 3 times, while Apple has done 5 already. These companies attempt to keep their share prices reasonably priced to make them more appealing to the masses.
Famously, Berkshire Hathaway has never split their Class A shares. CEO Warren Buffett has made this decision and never wants to do a split. He thinks the company is more attractive to investors with a really high share price. He seeks long-term value and growth in companies and wants to attract like-minded investors to buy shares of his own company. In his view, the high share price helps to attract the right kind of investor he wants.
Stock Splitting Announcements
So the real question here is how should you trade stock splits? This can depend heavily on your specific situation and even the company, but I do have some general tips from things I've observed in the market. In most cases, when a stock split is first announced to the public, the share prices will often increase immediately. However, this rally often fades away just as quickly.
If I own shares of a company short-term and plan to sell them when I've made a decent profit, I will often sell shortly after a stock split announcement. As the prices starts to shoot up, I unload my existing shares into this rally. In many cases, this ends up being one of the best share prices to sell at in the near future. Long-term holders don't really need to worry too much about splits, since the price will usually level out over time.
When you do not own shares of a company and see a split announcement, should you buy? Unless you saw this news less than a minute after it was released, you shouldn't buy yet. A quick reaction to the announcement may be able to perform a quick day trade where you buy into a position and exit it within an hour or two. Otherwise, you should wait. After the brief rally, the price will usually dip back down. That dip is a better place to buy for a longer position.
Stock Split Dates
After the announcement comes the actual stock splitting date. All announcements will tell you when this split happens, so anyone holding shares on that date will have them split automatically. You will sometimes see a bit of a rally leading up to the split date as retail investors obtain shares, but this action isn't usually as intense as it was on the announcement date. After the split, the share price will often drop.
When I first got started, I bought some shares when a split was announced. After the split, my investment had lost money, and it took months to get back to break even. While this won't always be the case with all companies, this does seem to happen more often than not.
Even though it completely contradicts the psychology of a stock split, I believe the best time to buy is actually after the split. You can often get the shares for the best price and put yourself in the best position to make a profitable trade. Wait for the dip after the split happens and then buy. You should be able to buy the same number of shares that you would've had buying before the split but at a lower overall cost.