A New Way to Grab Big Gains

Though we’re in the dead of winter, it feels like the dog days of summer at the moment. We’ve had no trades for several weeks, and our new earnings season is still a couple weeks off.

During the lull, I’ve been plowing through a decade of data on stock splits — those corporate events when a company decides to either increase or decrease the number of shares outstanding.

And based on that wealth of historical data, I’ve discovered that if we traded on stock splits that met specific parameters — we would’ve experienced an incredible win rate between about 70% and 90%.

So I’ve decided to include a new type of trading in our Earnings Drift Alert system — based on the “stock-split drift.”

Behind the Stock-Split Trend

In most instances, a company increases the number of shares during a stock split, typically as a way to make a high share price more affordable to Main Street investors.

A good example of this was Monster Beverage, one of the companies we traded in Earnings Drift Alert. Back in November, the company split its shares 3 for 1, meaning each share that was then trading up near $127 instantly became three shares trading at $42.33 each. (We didn’t fare well with our stake in Monster tied to an earnings report, but that’s a different matter.)

My interest in stock splits comes from my days with The Wall Street Journal. It was back when I was writing the “Heard on the Street” column in Dallas, and I had befriended a finance professor at Rice University in Houston named David Ikenberry.

I was sitting in David’s professorial office, surrounded by books and whatnot, as he explained some of his latest research: What do stock splits really signal?

As a numbers geek and a market observer, his research was fascinating to me.

In theory, a stock split should be a nonevent. I mean, what’s the difference between one share worth $100 or two shares worth $50? Nothing, in practical terms.

But Wall Street is as much psychology as it is practical numbers. And David’s research had shown empirically that stock splits carry their own psychological impact — a bullish impact.

He looked at more than 1,200 splits that had happened over a multiyear period in the ‘90s and found that stocks that had split ultimately went on to outperform the market by 8% in year one, then 12% over the next three years.

A couple of reasons exist for this, both psychological:

  • All things being equal, a lower share price is more attractive to buyers because they can afford more shares for the same amount of money. So there are more buyers for a stock that has split its shares.
  • A split is often a sign that management is bullish on the company’s future. After all, no executive wants to cut his share price in half or more — and then see the shares continue to drift lower. So management tends to proffer stock splits when the company’s operations are performing well. Indeed, managements routinely announce stock splits at the same time they report strong earnings growth.

Playing Stock Splits With Options

Of course, we don’t have the luxury of holding a stock for a year or three in order to capture the likely gains. So I dug into the options market to see how stock splits have historically played through companies over periods ranging from two days to one year, looking for a sweet spot we might take advantage of in Earnings Drift Alert.

I examined 10 years of stock-split data from a large number of small-, mid- and large-cap stocks that trade on the NYSE, etc.

And sweet spots began to emerge.

For instance, I can tell you what’s likely when a large-cap New York Stock Exchange company announces a split (we have short-term opportunities that will play out in a few days and longer holds of many months) versus what’s likely when a small-cap NYSE company announces a reverse split (when these companies reduce their share count, it’s usually a reason to own puts).

I know what to expect with a Nasdaq Global Select company (holding periods are months, not days) versus a company that trades on the Nasdaq Capital Market (the win rate is smaller, meaning the risk is larger).

As such, our in-house investment research expert, Chad Shoop, and I are now tracking stock splits, and when opportunities to trade them pop up, you will receive an alert.

I’ll give you a couple examples of what would have happened with the crop of stock splits from 2016:

  • SS&C Technologies Holdings (Nasdaq: SSNC) split its shares 2 for 1 back in late June. By early October, the options we would have played were up 196%.
  • Intercontinental Exchange (NYSE: ICE) split its shares 5 for 1 in early November. Four days later, the shares were up 8%, and the options we would have traded were up 175%.
  • Hormel Foods (NYSE: HRL) split its shares 2 for 1 back in February. A week later, the options we would have traded were up 116%.

I’m not saying every trade would have been a winner. That’s certainly not the case. But the sweet spots I’ve identified have a win rate, as I noted above, of between roughly 70% and 90%, depending on the market cap of the company, the holding period, the type of split announced and other factors I’ve taken into account.

But I will tell you more about all of that when we get around to making our first trade based on a stock split.

So, that’s what I’ve been up to during this lull. And it’s why, along with profiting from corporate earnings reports, we will begin looking to profit from stock splits.

In the meantime, if you have any questions about this addition to the system, please don’t hesitate to send me an email at earningsdrift@sovereignsociety.com.

Until next week, good trading…

Jeff Opdyke
Editor, Earnings Drift Alert