Stock Splits, Trading Continuity, and the Cost of Equity Capital

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Stock Splits, Trading Continuity, and the Cost of
Equity Capital

• Ji-Chai Lin
• Louisiana State University
• Ajai K. Singh
• Case Western Reserve University
• Wen Yu
• University of St. Thomas
• For presentation at NTU, December 2008
• Comments welcome

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• "You better cut the pizza in four pieces because
  I'm not hungry enough to eat six."
• Yogi Berra, when asked if he wanted his pizza
  cut into four or six pieces.

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Stock Splits A Simple Corporate Event

• For example,
• a firm has 10 million shares outstanding, traded
  at 50 per share.
• If the firm announces a 2-for-1 split,
• Its investors will receive one new share for
  every old share they have.
• So, the number of outstanding shares would
  increase to 20 million and presumably price per
  share would decrease to 25.
• What difference does it make?

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A Puzzling Issue

• Managers often indicate that stock splits are
  intended to improve liquidity.
• Contrary to Managers view, studies find splits
  induce reduction in liquidity, based on bid-ask
  spreads and share turnovers.
• Copeland (1979), Conroy, Harris and Benet (1990),
  and Easley, OHara and Saar (2001), Gray, Smith
  and Whaley (2003).
• How to resolve the conflict?

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Why a split per se is necessary is unclear.
-- Easley,OHara and Saar (2001)

• Stock splits remain one of the most popular and
  least understood phenomena in equity markets
• empirical research has documented a wide range of
  negative effects, such as
• increased volatility,
• larger proportional spreads and
• larger transaction costs following the splits.
• On balance, it remains a puzzle why companies
  ever split their shares.

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On the Positive Side

• The market reacts positively to stock split
  announcements.
• The average announcement return is about 3.4.
• The question is
• What are the benefits from stock splits?

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A New Perspective

• Our premise
• non-trading reflects illiquidity
• Lesmond, Ogden, and Trzcinka (1999), Lesmond
  (2005), Liu (2006), and Bekaert, Harvey and
  Lundbald (2007).
• Trading decision is endogenous and a function of
  trading costs
• Informed investors would trade only if the value
  of information exceeds trading cost
• liquidity traders may refrain from trading if
  trading costs outweigh the improvement in
  portfolio allocation.
• This implies
• firms with greater incidence of no trading face
  higher (unobservable) trading costs and lower
  liquidity.

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Drawbacks of Conventional Liquidity Measures

• Bid-ask spread
• the bid and ask quotes are often for small-size
  trades whereas a larger transaction size may need
  to be negotiated.
• Kyles (1985) lambda and Amihuds (2002)
  illiquidity measure
• because of the endogeneity of the trading
  decision, these measures may not be able to fully
  capture the illiquidity of non-trading.

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The Trading Continuity Hypothesis

• Our hypothesis posits that,
• for a firm facing some possibility of trading
  discontinuity,
• managers have incentives to use a stock split to
  attract more uninformed traders to participate in
  trading their stock.
• More uninformed trading allows market makers to
  reduce
• inventory holding cost and
• adverse information cost.
• As liquidity improves,
• investors face lower liquidity risk and require a
  lower liquidity premium,
• which in turn reduces the cost of equity capital
  for the firm, and increases firm value.
• We propose this hypothesis to explain
• how a stock split may improve liquidity and
• why it could be beneficial to the firm.

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Measuring Trading Discontinuity

• To measure trading discontinuity, we use Lius
  (2006) LM12,
• the standardized turnover adjusted number of days
  with zero trading volume over the prior 12
  months.

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Liquidity-Augmented CAPM

• Liu (2006) proposes a two-factor
  liquidity-augmented CAPM
• Similar to Fama and Frenchs SMB and HML, Liu
  constructs LIQ as
• the return difference between a low liquidity
  portfolio (containing stocks with high LM12) and
  a high-liquidity portfolio (containing stocks
  with low LM12).
• Liu (2006) demonstrates, this model performs
  better than
• Fama and Frenchs three-factor model and
• Pastor and Stambaughs (2003) asset pricing model
  
• in explaining the cross-section of stock returns.
• This model can also explain anomalies associated
  with
• firm size,
• B/M,
• cash flow-to-price ratio,
• dividend yield,
• earnings-to-price ratio, and
• long-term contrarian investment strategies.

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Main Findings

• We use a large sample of stock splits to test our
  hypothesis.
• Consistent with our hypothesis, we find that
  following the splits,
• incidence of no trading decreases (implying lower
  latent costs of trading),
• liquidity risk is mitigated, and
• the cost of equity capital is reduced.
• The split announcement returns are correlated
  with the improvements in both the liquidity level
  and liquidity risk.
• On average, the liquidity improvements reduce the
  cost of equity capital by 17.3 percent, or 2.42
  per annum,
• suggesting that the economic benefits of stock
  splits are nontrivial.

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Data

• Our sample 3,721 stock splits
• the CRSP files,
• ordinary single-class common stocks,
• a split factor of one or higher,
• pre-split price of 10 or above,
• size and B/M available,
• Trading volume available,
• 1975-2004 period.
• By exchange
• 2,109 splits from NYSE/AMEX firms,
• 1,612 splits from Nasdaq firms.
• By the split factor
• 3,399 splits have a split factor equal to one
• 267 splits with a split factor between 1 and 2
• the remaining 53 with a split factor above two.

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Stock Splits and Changes in Sample
Characteristics
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Table 3 The Effects of Stock Splits on Trading
Continuity

• For each split firm, we choose a benchmark firm,
  which is
• a non-split firm
• whose price is closest to that of the split firm
  at month -1,
• in the same size and the same B/M quartile as the
  split firm.

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The effects of stock splits are long term.
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Split factor and Pre-split Trading Discontinuity

• Firms appear to choose a higher split factor when
  their stocks have more trading discontinuity.
• Firms choosing a higher split factor seem to
  experience more improvement in trading continuity
  following the split.

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Table 4. Cross-Sectional Analysis of the Split
Factor
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Table 5. Cross-Sectional Analysis of Changes in
Liquidity
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Table 6. Changes in Liquidity Risk
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How much would the cost of equity capital be
reduced for the split firms ?
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Figure 2. Pre-Split and Post-Split Liquidity Risk
of the Split Firms vs. Their Benchmark Firms
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Table 7. Cross-Sectional Analysis of Changes in
Liquidity Risk
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Table 8. Cross-Sectional Analysis of Split
Announcement Returns
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Conclusions Main Findings

• Despite extensive research on stock splits,
  Easley, OHara and Saar (2001) note that
• it remains a puzzle why companies ever split
  their shares.
• We propose and test
• the trading continuity improvement hypothesis.
• We examine a large sample of splits and find
  that, consistent with our hypothesis,
• trading continuity improves,
• liquidity risk is mitigated, and
• the cost of equity capital is reduced following
  the splits.

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Conclusions Supporting Evidence

• Firms facing more frequent trading
  discontinuities
• choose a higher split factor, and
• experience greater improvement in trading
  continuity.
• The split announcement returns tend to be higher
  for
• firms with more liquidity improvements.
• These results further suggest that
• reducing the possibility of trading discontinuity
  is
• an important factor in firms split decisions.

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Final Comment

• Overall, our study provides an explanation with
  economic benefits for
• why companies split their shares.
• It is consistent with managers view that
• stock splits are intended for improving liquidity.