Summary:
– Share prices on the US market have fluctuated around $30 since the 1930s, thanks to the regular practice of stock splits.
– Several explanations can be put forward: the existence of budgetary constraints for investors, the desire to increase the liquidity of securities, the sending of a signal, and finally the existence of a standard.
– The existence of a standard seems to be the most plausible explanation for the US market.
– The French case is not as clear-cut.
Surprisingly, the law of supply and demand is not the only factor determining share prices on the stock markets. Companies, mainly American, regularly carry out stock splits in order to actively manage their share prices. Stock splits are legal transactions that involve subdividing a security on the secondary market, such as a share, into several securities with the same characteristics but at a lower price. It is a simple accounting operation that does not require the issuance of new shares. A shareholder owning one share at $100 may therefore see their share subdivided into two shares at $50. A stock split is supposed to be a neutral transaction that does not affect the total value of the company or its financial structure, and does not change the value of the shares held by shareholders. General Electric has regularly used this practice because, with a nominal price (unadjusted for inflation) of $38 in 1935, the price in 2005 should have been $10094, whereas it was only $35.
However, this remains a surprising practice, given that this financial operation has a significant cost for the company that carries it out. But above all because it can generate very high costs for investors if they pay transaction costs proportional to the number of shares (which is less and less the case, as the cost has become proportional to the total amount alone).
However, if we examine the average nominal price of shares in the United States between 1975 and 2005, as studied by Benartzi et al. (2009), it remains very close to $30, while the Dow Jones index increased sixfold over the same period [Graph 1].
Graph 1: New York Stock Exchange
In black: average nominal share price weighted by company capitalization (in dollars),in gray: Dow Jones, Source: Benartzi et al. (2009).
Some companies, particularly American ones, therefore seem to actively manage the nominal price of their shares. Several reasons can be put forward to explain this behavior: the existence of a budget constraint (1) on investors, the desire to increase the liquidity of securities (2), the sending of a signal (3) and, finally, the existence of a norm (4). However, all of these reasons, with the exception of the theory of the existence of a norm, prove to be unsuccessful.
The theory of budgetary constraints
The theory of budget constraints considers that each investor seeks to diversify their investments as much as possible within the constraints of a limited budget. Low-priced securities make it easier to diversify a portfolio and would therefore be in greater demand. According to a survey cited by Benartzi et al. (2009), 40% of Money Market Fund (MMF) managers in the United States are convinced that a lower value attracts investors. However, MMFs are, by definition, funds that are already relatively well diversified and whose shares, unlike stocks, are divisible.
Furthermore, if investors’ budget constraints were the driving force behind the active management of nominal share prices, the latter should more or less follow the trend in inflation: real prices should be relatively stable. However, we can see that in the United States [Chart 2] and France [Chart 3], average real share prices have been falling over the periods considered.
Chart 2: Average real share prices in the United States
In black: average real price weighted by company capitalization; in gray: average real price unweighted; Source: Benartzi et al. (2009).
Chart 3: Average real share price in France (based on the euro 2000 index)
Source: Macrobond, BS-Initiative.
The budget constraint theory also assumes that non-institutional investors have a preference for relatively low-priced stocks, since they are the ones with the greatest budget constraints. Conversely, institutional investors should prefer higher stock prices in order to reduce their transaction costs when these are based on the number of shares. However, in the United States, the share of non-institutional investors fell from 90% in 1950 to 41% in 1998, without this leading to an increase in share prices. The explanation for the practice of stock splits and the maintenance of a relatively constant nominal price in the United States and, to a lesser extent, in France is therefore not to be found in budgetary constraints.
The liquidity theory
Intuitively, one might think that low-priced securities are the most liquid, if liquidity is defined as the ease with which a security can be resold. This is because reselling a share at $100 requires finding a single buyer willing to pay that amount, whereas reselling ten shares at $10 can be done with several buyers. However, examples such as Google (whose shares trade at around $1,000) and Berkshire Hathaway (whose Class A shares, which carry voting rights unlike Class B shares, are worth around $170,000), whose shares are highly liquid despite their very high price, challenge this initial intuition.
Furthermore, according to Angel (1997), the greater the ratio between the minimum possible difference (tick size) between the bid and ask prices (bid-ask spread) and the share price, the higher the brokers’ earnings, and therefore the more they tend to trade that security, making it more liquid. For example, with a tick size of $0.01, a $10 stock will have a ratio of 0.1%, while for a $1 stock, the ratio will be 1%. However, as this tick size is regulated, the only way to attract brokers by increasing their earnings is to reduce the price of the shares. Thus, a lower share price encourages brokers to trade the security. Nevertheless, the reduction in tick size due to the switch to electronic trading (from 1/8th to 1/100th of a dollar during the 1990s) did not result in a fall in the average share price, which, by preserving brokers’ profits, would have confirmed the liquidity theory.
Signaling theory
There are significant information asymmetries between managers and investors. According to this theory, a stock split would be a way for a company to signal strong future growth to investors through the stock market. By lowering its share price, a company signals that it is undervalued relative to its competitors and therefore has growth opportunities. Furthermore, for a signal to be credible, it must be costly, because if it were not, all companies could send this signal, rendering it useless. Only companies willing to risk losing a lot can generate a credible signal. However, the administrative and legal costs of a stock split are estimated at around $500,000, to which must be added the increase in transaction costs for investors, when these depend on the number of shares. Stock splits therefore seem to send a strong signal.
Despite the fact that the market seems to respond positively in the short term, according to the study by Lakonishok and Lev (1987), companies that announce a stock split have tended to reach a peak in growth before the announcement. Furthermore, the decision to carry out a stock split within the framework of signaling theory is unpredictable, as it depends on private, internal company information that the company is seeking to signal. The peak in growth prior to the stock split cannot therefore be explained by the market’s anticipation of the split. Ultimately, the stock split would therefore be more of a negative signal for investors, or even neutral. When passive index funds such as ETFs (Exchange Traded Funds) carry out stock splits, they do not produce any information. Finally, if companies were seeking to produce information through these stock splits, their share prices would have to seek to differentiate themselves from those of other companies, but we see that stock splits tend to cause share prices to converge towards a certain average price. Signal theory therefore has no more explanatory power than previous theories.
The norm theory
For several decades now, the perfect rationality of economic agents has been called into question. Today, it is more relevant to talk about limited rationality. Norm theory is part of this trend, relying on the values and beliefs to which investors and companies are subject, sometimes without even being aware of it. The norm of shares trading at around $30 in the United States is a convention which, when respected by companies, increases the confidence placed in them by the market ( the norm should be understood as a range of values within which the share price varies according to supply and demand). According to Benartzi et al. (2009), while this standard was probably originally established based on real economic constraints (budgetary, liquidity, etc.), the fact that it was established after the 1929 crisis gave it a very strong psychological dimension. This may explain why it persists today despite the disappearance of many economic constraints. There does not appear to be a similar norm in France, at least not for the period 1933-2009. On the other hand, the average nominal price of French shares seems to have converged towards €50 since the creation of the euro zone, but the period is too short to be able to speak of a norm.
Benartzi et al. (2009) studied the probability of a company implementing a stock split based on the difference between its share price and the average of other companies in the same sector. Their results show that a company whose share price deviates from the norm for its sector will be more likely to carry out a stock split. There is a kind of desire to return to the norm in the event of a deviation. Benartzi et al. (2009) also studied average nominal prices by classifying companies according to their size [Figure 4].
Figure 4: Change in the average nominal share prices of companies listed on the Dow Jones index according to their size
From top to bottom: quintile 1, quintile 2, quintile 3, quintile 4, quintile 5. Source: Benartzi et al. (2009)
There are clearly different standards depending on the size of the company. The share price would therefore also be a way for the company to assert its status by aligning itself with a group of peers. In France, none of the top five market capitalizations have a price below €40, and some even exceed €100 (L’Oréal and LVMH), which also seems to support the idea of the existence of norms.
Conclusion
The existence of a standard within the US financial market seems to be the best explanation for therelatively constant nominal price on the US stock market.
Compliance with a norm depending on the sector and, above all, the size of the companies seems to be a well-established practice in the United States.
In France, there is clearly active management of nominal share prices. However, it seems difficult to talk about a standard per se, except perhaps since the transition to the euro, when share prices seem to have fluctuated around €50. But the period studied is too short to draw any conclusions.
Bibliography:
Weld.W, Michaely.R, Thaler.R and Benartzi.S, 2009, “The Nominal Share Price Puzzle”, Journal of Economic Perspectives—Volume 23, Number 2—Spring 2009—Pages 121–142
Angel.J, 1997, “Tick Size, Share Prices, and Stock Splits”, Journal of Finance 52, 655-681.
Lakonishok.J, and Lev.B, 1987, “Stock Splits and Stock Dividends: Why, Who and When”, Journal of Finance 42, 913-932.
