Trading Stock Splits and Share Consolidation
Stock splits have been in the news quite a lot recently. You have probably read about listed companies, like Apple and Tesla, splitting their shares. But what exactly is a stock split? And what about the opposite of a stock split - known as share consolidation?
In this article we will answer these questions, explaining what stock splits and share consolidations are, as well as providing examples of both. We will also take a look at whether it is possible to profit by trading stock splits and share consolidations.
Table of Contents
What is a Stock Split?
A stock split occurs when a company decides to increase the number of shares it has outstanding and distributes the new shares to existing shareholders in proportion to their current holdings.
Let's illustrate this with an example:
- Corporation XYZ has 100,000 shares outstanding
- You own 1,000 of these shares, or 1% of the total shares outstanding
- Current share price of XYZ = £1
- Your total share value = £1,000
XYZ then announces that, on the first trading day of November, it is going to split its shares on a 5 for 1 basis.
Therefore, on the first trading day of November, the following will be true:
- XYZ will have 500,000 shares outstanding (100,000 x 5)
- You will own 5,000 shares (1,000 x 5)
Every other shareholder will also receive additional shares in proportion to their holding and you will note from the above, that even though you now own more shares, you still only own 1% of the shares outstanding.
Does a Stock Split Increase the Value of Your Holding?
Unfortunately, the answer is typically "no".
In the previous example, when the last trading day of October comes to an end, stockbrokers and registrars adjust their documentation to reflect shareholders' new holdings. Furthermore, companies like the exchanges, Bloomberg and the Financial Times, whose responsibilities include reporting share prices, adjust the official closing price of XYZ's shares to be 1/5th of the price at close.
Let's say, for simplicity, that XYZ's shares closed at exactly £1.00 per share on the last trading day of October. After the adjustments described above are made, your 1,000 shares, priced at £1.00 each, become 5,000 shares priced at £0.20 each. Therefore, the value of your holding at this stage is exactly the same: £1,000.
Similarly, although the company has 5 times as many shares in issue, its market capitalisation stays the same.
In theory, the total value of any company does not change just because the number of shares outstanding has increased. But is this what happens in practice? Before we answer that question and look into trading stock splits, it is worth looking at what the reasons behind the splits are in the first place.
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Why Would a Company Split its Shares?
The most common motive for companies to split their shares is to facilitate liquidity in the market. This is best explained with a real-life example.
In January 2010 shares in Warren Buffet's company, Berkshire Hathaway's B shares, were trading at almost $3,500 for one share. That meant that if you wanted to invest in the legendary "Wizard of Omaha's" company, you had to find at least $3,500 to buy one share. Not everyone has the ability to do that.
If, conversely, you were an existing shareholder who had enjoyed steady rises in a past investment in Berkshire and now wanted to sell enough shares to fund a $1,500 holiday, you would have had to sell at least one share - generating more cash than you needed and probably more tax liability than you wanted. If you held other shares that allowed you to generate a sum closer to the $1,500 you needed, you would probably choose to sell those instead.
You can see from these two examples that when share prices are too high, trading can become awkward and, therefore, less frequent. An increase in the amount of shares outstanding translates to an increase in convenience and prompts more trades to take place, making the market for the shares more liquid.
Increased liquidity narrows the spread of the shares and makes owning them less risky (because they are now easier to sell). This leads to a slight increase in demand and that, in turn, lowers the cost of capital for the company. This is the main incentive for companies to split their shares.
Trading Stock Splits
So now we are aware of what a stock split is and why a company might undertake one, but is it possible to use this information to our advantage and start trading stock splits?
In theory, just because a company has more shares in circulation, it should not be worth any more than before, any change in share price will be determined by how investors react to the announcement. Successfully trading stock splits, therefore, requires successfully predicting the market’s reaction.
Companies that split their shares are, by definition, those with high share prices – those that have seen big rises in the past and whose shares are on a long-term upward trend. The announcement of a split causes more people to notice this.
Therefore, a stock split is seen by many as a buying signal and its announcement is often followed by an increase in demand for the company’s shares and consequently the share price being pushed higher.
Moreover, when the split actually occurs, the share price becomes more affordable to a wider audience - this coupled with an increase in liquidity can also boost demand and price.
In the earlier example, Berkshire Hathaway implemented a 50 for 1 split for its B shares in January 2010 and this was welcomed by the market with a 5% jump in the share price during the first 30 minutes of trading after the split came into effect. After that, the price resumed its long term upward trajectory at a slightly faster pace than before the split.
However, not every stock split is accompanied by a bullish movement in share price and the difficulty in trading stock splits lies in determining which shares will benefit from a split and which ones won’t. This makes constructing an all encompassing stock split trading strategy difficult.
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Examples of Recent Stock Splits
Recent examples of companies splitting their shares include, of course, Apple and Tesla.
Example 1. Apple
On the 30 July 2020, with its stock at $380, Apple announced a 4 for 1 stock split. The share price was already on an upward trend but the announcement accelerated the trend and three weeks later the shares were at $497 – a 30% increase. By the 1st September Apple's market-cap reached $2.3Tr., surpassing the value of the entire FTSE100 ($2.1Tr. on the same day).
There are many reasons for Apple's success but its positive share price trend clearly accelerated after news of the split. This can be seen in the chart below, with the vertical red line indicating the date which Apple announced their most recent stock split.
Example 2. Tesla
The day before Tesla's announcement of a 5 for 1 split on the 11 August 2020, their share price closed at $1,405.30. The announcement saw share prices immediately jump by 7% in after-hours trading. Tesla said it did it "to make stock ownership more accessible to employees and investors".
The company's already buoyant share price increased 57% in the two weeks after the announcement – without any additional news. On 28 August, the last trading session before the split took effect, Tesla's share price closed at $2,213.40.
Roughly 3 weeks after announcing the split, Tesla made a statement that it would raise up to $5bn by selling new shares, underlining the motive behind its share split.
Share splits were very popular during the late 1990s – in 1999 there were more than 85 among S&P 500 companies alone. But they had fallen out of fashion, with only five taking place among this same group of companies in 2019. However, the success seen by Apple and Tesla may encourage other CEOs to consider share splits.
What Is Share Consolidation?
A share consolidation, also known as a reverse stock split, is the exact opposite of share splits. They consolidate the number of outstanding shares in the same proportion for all shareholders.
Share consolidations are normally carried out by companies who have seen large drops in their share price over a period of time and are often seen as a sign of a company in trouble.
The official reasons given for share consolidations are usually practical, "to simplify trading for our shareholders", for example.
But when investors see a "penny stock", they assume the company behind the share is an underperformer. A share consolidation is a good way to hide this, at least temporarily.
In addition to the optics, some US exchanges (NASDAQ, for example) have rules which allow the exchange to delist shares that persistently trade below $1. A reverse split is a quick fix for that potential problem.
Share Consolidation Trading
As we have noted, a share consolidation is usually perceived as a sign that a company is in trouble and often results in a continued downward trend.
Whereas a stock split is viewed by investors as a bullish signal, a share consolidation is very much a bearish signal and an indication that the share price could be set to fall further.
Traders who agree with this conclusion may choose to use Contracts For Difference (CFDs) to short sell a company's shares once a share consolidation has been announced.
CFDs allow traders to speculate on both rising and falling prices, whilst also benefiting from the use of leverage.
A Share Consolidation in Action
In March 2017 Bank of Ireland (BoI) announced a 30 to 1 reverse-split of its shares. Before the consolidation BoI had 32bn shares outstanding and, with shares trading at around €0.23; a market capitalisation of around €7.6bn.
The large number of shares was partly the result of capital injected by the Irish government at the time of the 2008 financial crisis when the bank was in trouble.
Straight after consolidation the shares traded in line with market capitalisation, at €7 each, but they soon resumed their downward trajectory and, by September 2020, they were trading below €2.
Final Thoughts
As we have seen above, stock splits are a signal that a company has enjoyed increases in its share price and expects more of the same. Share consolidations indicate the exact opposite.
Many traders and investors use these as prompts to take a position in or against the company. Others use it as a trigger to take a closer look at a company, to do more analysis before taking a position. The more angles you look at a potential trade from, the more likely you are to succeed.
Although, as we have seen, when a company announces a stock split, it can lead to an increase in share price, this is not necessarily always the case. It is important to remember that a share split itself does not have any effect on the value of a company. Rather, it is the way the market reacts to the news of the split which will cause any consequential price movements. The same is also true for share consolidations.
Therefore, it is recommended that, before trading stock splits, find out as much as you can about the company. Learn about the drivers behind the company's decision, read the company's news, analyse their fundamentals and look at technical indicators to examine recent price movements.
Stock splits and share consolidations are normally announced weeks before they are implemented and sometimes there are rumours of them beforehand, giving a trader more time to think about what action to take.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
