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Illusion, Perception and Reality: Stock Splits and Index Inclusions

Without examples, these are abstractions, but before I cite examples for each, I want to emphasize that there are very few events that have only one effect, and that most have a dominant effect (on value, price or the gap) with secondary effects on the others.
  1. Mostly value events: When a manufacturing company adds to its production capacity or a retailer opens new stores, the effects will almost entirely be on value. Since these actions are generally in the normal course of operations for these firms, they are unlikely to attract new market attention (which you need for gap events) or change market mood and momentum. Higher profile actions, though, almost always have spillover effects, and here are two examples. When Walmart recently announced its intent to partner with Microsoft Corporation (NASDAQ: MSFT) to buy TikTok, there is clearly a value impact that this action will have, costing tens of billions in current cash flows, while promising to deliver higher growth and cash flows in the future. At the same time, though, this action, by attracting tech investors to buy Walmart, may alter momentum and have a secondary impact on pricing. When a California court ruled against ride sharing companies a few weeks ago, on the issue of drivers being employees rather than independent contractors, that decision had consequences for cost structure and value for Uber and Lyft, but it may have induced some investors to look at the gap between price and value at these companies.
  2. Mostly gap events: Gap events can be initiated either by the companies that are being mispriced (or at least perceive themselves to be mispriced) or by investors with the same perception. In academic finance, these events are termed signals, and while there is no guarantee that they will work, the motivation is to try to close the perceived gap between price and value. The cleanest example that I can offer for a gap event is a spin off or a split up, where a multi business company spins off one or more of its businesses or splits itself up, with no consequential changes in how it is run as a company, but with two objectives. One is that the action will expose the disconnect between the underlying fundamentals and the pricing, by providing more transparency on cash flows, growth and risk of individual businesses. The other is that the action will draw investor attention to the company, and that the attention can lead to a repricing of the stock. Not all gap events originate with the company. When activist investors target a company either as a buy or a short sale, they are attempting to provide the catalysts for the pricing gap to close, though their end games may involve changing the way the company is run, thus affecting cash flows, risk and value.
  3. Mostly pricing events: With mostly pricing events, the end game is altering mood and momentum or changing the liquidity in the stock, and by doing so, affecting the pricing of a stock. An emerging market company that lists its shares on a more liquid, developed market exchange, for instance, has clearly not altered its fundamentals through that action, but may benefit from higher liquidity pushing up price. There can be spillover effects from increased information disclosure, perhaps helping to close gaps between price and value, and perhaps even greater access to capital, allowing for a value effect.
Finally, there are some events that can fall into any of the three buckets, depending upon who initiates the event and how the market views the initiator. Stock buybacks are perhaps the best example, since there are arguments you can make for buybacks to be value, gap or pricing events.

– If companies buy back stock, using borrowed money, the primary intent may be to change value by altering the financing mix and the overall cost of capital for the companies.

– In contrast, if companies buy back stock, but only if they perceive their shares to be under valued, the buyback becomes a gap event, focused on moving prices up to intrinsic value.

– Finally, if companies buy back stock to feed pricing momentum or to provide a floor to the price, buybacks are primarily pricing events. The question for today then becomes where stock splits and index inclusions fall in this spectrum of value, gap and pricing events.

There is one final point that needs to be made about all these events. With each event, there are two dates of note. The first is the announcement date, when the market learns about the event, albeit it with some leakage to insiders ahead of the date. The second is the action date, when the event actually happens. Almost every effect that I described in this section should happen on or around the announcement date, and action dates are largely ceremonial. Put simply, if you believe that an acquisition, a spin off or a developed market listing is going to have an effect on price, the time to take investment action is at the time that it is announced, not when it happens.