The split announcement returns and O/S

How much stock undervaluation exists prior to stock splits? Because our hypothesis suggests that, by using stock splits to attract more new investors to facilitate existing

shareholders’ portfolio rebalancing needs, firms can resolve the undervaluation problem, the split announcement returns are a good measure of the extent of stock undervaluation prior to stock splits. As shown in Table 1, the average split announcement return is 2.8%, suggesting that, on average, pre-split undervaluation is about 2.8% of firm value in our sample firms.

Table 8 reports the results of regressing the five-day split announcement returns on pre-split O/S, the natural logarithm of average O/S over days –22 to –3, and a set of control variables, including firm size, B/M, pre-split price run-up, pre-split stock price level, the split factor, and changes in stock liquidity.⁹ The regression results show that the O/S is significant, with a coefficient ranging from 0.004 (t-value = 2.78) to 0.006 (t-value = 3.50) in various specifications.

The finding suggests that pre-split O/S is informative about the extent of pre-split undervaluation:

The higher the undervaluation, the more the informed traders use listed options. To recoup the undervaluation, firms use stock splits, and their stock prices go up on the split announcement.

<<TABLE 8 ABOUT HERE>>

The association between the split announcement returns and pre-split O/S has two implications. First, it strengthens our argument that the rise in pre-split O/S reflects more informed trading in the options over the stocks. Second, split firms with more pre-split O/S benefit more from announcing a stock split.

Our finding that informed traders know in advance about stock undervaluation prior to split announcements casts doubt on the validity of the signaling hypothesis that managers use stock splits to signal their firms’ future prospects. Rather, the evidence is consistent with our

9 Lin, Singh, and Yu (2009) suggest that part of the split announcement return reflects anticipated improvement in stock liquidity following stock splits. Hence, we use three proxies—change in turnover, change in Amihud’s (2002) illiquidity, and change in Liu’s (2006) LM—for change in stock liquidity to control for its valuation effect.

hypothesis that shareholders’ portfolio rebalancing needs induced by significant stock price run-ups have a negative valuation effect if the firm cannot attract sufficient buying interests and that the firm overcome the negative valuation effect by using a stock split to attract new investors to offset the selling pressure from shareholders.

6. Conclusion

Chordia, Huh, and Subrahmanyam (2007) note that stock price changes naturally lead to investors’ portfolio rebalancing needs. Motivated by their study, we consider the possibility that a firm may experience “growing pains” when its stock price has grown substantially but its investor base has not changed much. The substantial rise in equity value makes the firm overweight in its shareholders’ portfolios, causing them to face unnecessary firm-specific risk and creating portfolio rebalancing needs.

To rebalance their portfolios, shareholders must sell part of their holdings on the firm.

Even though they may not sell at the same time, selling pressure builds. Thus, we hypothesize that if the firm cannot attract sufficient buying interests, selling pressure from existing shareholders’ portfolio rebalancing needs induced by substantial price run-ups leads to stock undervaluation. The firm can resolve the undervaluation problem by splitting its shares to attract new investors to better facilitate its existing shareholders’ portfolio rebalancing needs.

Indeed, we find evidence that common shareholders, including institutional investors, balance their portfolios following stock splits. The extent of their portfolio rebalancing, as proxied by the decrease in the average percentage holding per shareholder or per institutional investor, is significantly related to pre-split stock price run-ups. Another indication for portfolio

rebalancing needs increasing with past price run-ups is that share turnover in the months surrounding stock splits is significantly and positively related to past price run-ups.

Furthermore, stock returns are also positively related to past price run-ups, creating a price momentum, in the five months prior to stock splits. The price momentum largely disappears in the post-split period. The evidence is consistent with our hypothesis that selling pressure from shareholders’ portfolio rebalancing needs leads to stock undervaluation and that, by attracting more new investors to offset the selling pressure, stock splits recoup the undervaluation and make the market more efficient.

Because stock undervaluation makes listed options more appealing to informed traders, we find that O/S, the relative trading of options over stock, increases visibly in the pre-split period, particularly in the five months prior to split announcements. Moreover, the predictive power of O/S on future stock returns is able to subsume the price momentum effect in the pre-split period, suggesting that the price momentum and the increasing appeal of listed options have a common underlying factor in stock undervaluation.

The split announcement returns are also significantly related to pre-split O/S. However, after stock splits, as the market becomes more efficient, O/S declines and has no more predictive power on future returns.

Overall, we find compelling evidence that informed traders exploit stock undervaluation in the pre-split period and that stock splits are able to resolve the undervaluation problem. The evidence is more consistent with our hypothesis of portfolio rebalancing needs induced by significant price run-ups than the other theories, such as signaling and optimal trading range, proposed in the extant literature.

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