Here's the real reason why buying a stock after it splits can be a money maker

  • By Mark Hulbert,
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Would you be interested in a stock picking strategy that has beaten the stock market by 3.1 annualized percentage points over the last two decades?

I thought so.

Bulls can carry the markets higher

Ed Yardeni sees strong fundamentals continuing to send stocks higher.

Then why did an exchange-traded fund benchmarked to a stock-split strategy close down last year? My hunch is that investors weren’t really all that interested. At the latter stages of a bull market, investors pay little more than lip service to slow and steady strategies with strong long-term records. As greed takes over, people become irrationally exuberant. As a result beating the market by “just” three annualized percentage points just isn’t that exciting.

That’s a shame, not just for the strategy in question but for what it says about human nature. It’s because of this behavioral characteristic, after all, that bear markets become necessary and even desirable: They teach investors to have a healthy respect for risk, without which the economy becomes inefficient and reckless.

The strategy I am referring to was devised by Neil Macneale, editor of an advisory service called the 2-for-1 Stock Split Newsletter. His approach couldn’t be simpler: Each month he picks a stock that has recently split its shares, and it stays in his model portfolio for exactly 30 months. The exchange-traded fund created to follow the strategy, which ceased trading last fall, was the Stock Split Index Fund.

The New York Stock Exchange maintains an index of the 30 stocks that are held in Macneale’s model portfolio at any given time. Since July 1996, which is how far back the NYSE’s calculations go, the index has beaten the Wilshire 5000 index (.W5000) by an annualized margin of 12.1% to 9.0% (including dividends).

This market-beating performance shouldn’t come as a surprise, since a number of academic studies have reached a similar result. One of the first such studies was authored by David Ikenberry, a finance professor at the University of Colorado. Ikenberry believes the market-beating performance of stocks that have split their shares traces to a “sweet spot” in which the typical company likes to have its stock trade.

Though that sweet spot is not precisely defined, companies will not split their shares, even if the prices of those shares have risen sharply, if management believes there is a significant probability that shares of their company will fall back by themselves.

In effect, therefore, stock splits are a signal from management that they have confidence in the continued appreciation of their companies’ shares.

One test of this hypothesis is the performance of stocks that undergo a reverse split, in which the number of outstanding shares is reduced in order to increase the stock price. The signal being sent in such cases is just the reverse of what it is in the case of a regular (or forward) split, and — sure enough, according to researchers — such stocks proceed to lag the market after announcing their reverse splits.

Given the academic foundation of this so-called stock split effect, it’s perhaps not a surprise that some companies may now be trying to game the system by splitting their shares just to temporarily boost their stock prices. Macneale tries to guard against this by choosing the stock-split candidate each month that he believes is most undervalued. His most recent pick is Brown & Brown (BRO), the diversified insurance agency, whose shares split two-for-one in March. Brown & Brown was more attractively valued than two other stocks that also had split their shares: Fiserv (FISV) and Herbalife (HLF).

There’s a broader investment lesson here too: Don’t shun decent long-term strategies, especially when the rest of the investment public is carried away with get-rich-quick schemes.

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