Now, more than ever, investors are wondering just what the market will do. As they desperately look to recover portfolio losses after the market lows of 2008, investment strategy is certainly foremost on everyone’s minds. According to T. Clifton Green, an associate professor of finance and finance area coordinator at Emory University's Goizueta Business School, the key to investing, even in such a difficult environment, is in understanding market trends, as well as in taking a long-term approach. Nonetheless, his recent research suggests that investor behavior relies too heavily on sentiment and the categorizing of similarly priced stocks. This categorizing behavior, he notes, is not based on economic fundamentals or firm results.
In a research paper titled “Price-Based Return Comovement,” Green and co-author Byoung-Hyoun Hwang, a doctoral student in finance at Goizueta, use stock split data from the Center for Research in Security Prices to prove the point. The research paper is forthcoming in the Journal of Financial Economics. The paper notes, “Stock prices are unique in that they can be changed arbitrarily by altering the number of shares outstanding. This practice makes cross-sectional comparisons of price per share relatively meaningless.” Consequently, the pair looked at all ordinary common shares listed on the NYSE, AMEX and NASDAQ between 1926 and 2004, focusing on 2-for-1 splits and excluding stocks with post-split prices under $5.00 a share. The final split sample included 5,424 events, with the authors requiring stocks to have return data in the sample over a 12-month period ending one month before the split and over a 12-month period beginning one month after the split.
Green and Hwang found that the price of similarly priced stocks do appear to be relatively stable over a long period of time due to firm stock split behavior. The research paper notes that managers will split their stock when the per share price starts to deviate too much from their peers. Green surmises that institutional tradition might be driving this need to level out share price, keeping it in a set and expected range. The duo notes that prior researchers in the field determined that “nominal prices of common stocks have remained constant at around $30 per share since the Great Depression as a result of firms proactively splitting their stocks, which the researchers find difficult to fully rationalize.”
Interestingly, Green states that the drive to split a stock is driven by price-based stock categorization by investors. The paper adds, “If investors group stocks based on price, a firm with a stock price significantly different from its peers has the incentive to split rather than risk facing a smaller pool of investors.” The results indicate that price categorization, though often an arbitrary tool, remains a popular investing strategy. The authors add, “In the full cross-section, price-based portfolios explain variation in stock-level returns after controlling for movements in the market and industry portfolios as well as portfolios based on size, book-to-market, transaction costs, and return momentum.”
Green adds that investors also place some sort of value or meaning in the share price of the stock. Lower priced stocks tend to be of more interest to individual investors. He admits that it can be a complicated process to choose stocks for a portfolio, and investors can begin to rely on a variety of different methods, such as share price categorization, to come up with some sort of strategy. “But the price doesn’t really convey any specific information about the stock. Generally, splits are not based on capital structure issues.”
Nonetheless, the pair notes, “Taken together, our findings suggest nominal prices are relevant to investors when constructing and rebalancing their portfolios.” This irrational behavior does have its consequences. They add, “Price-based categorization of stocks has a material effect on return dynamics, and provides additional support to sentiment-based explanations for return comovement. Our results also offer a straightforward justification for 'trading range' motivations for splits and provide a potential explanation for the observed increase in volatility following splits.”
Overall, after a split, even without changes in a company, the now lower priced stock will travel in a new realm, more closely shadowing price changes (comoving) with lower priced stocks than with the ones it was previously priced near. The duo’s analysis “involves looking for shifts in split stocks’ comovement with price-indexed portfolios before and after the split.” The pair notes that stock splits cause significant changes in nominal prices with no resulting change in firms’ fundamentals. The paper states, “As such, they provide a relatively clean test of category-based investing with few confounding influences.”
Lower priced stocks are generally less liquid and receive much less attention from more sophisticated investors and traders. Institutional investors tend to favor higher priced stocks “beyond fundamental considerations.” The authors conclude that stock splits can often be a confounding influence on the market, deterring investment from more knowledgeable traders and creating significant clientele effects.