CHAPTER 1 CONCEPT AND REGULATORY FRAMEWORK OF STOCK SPLITS IN INDIA

Transcription

1 CHAPTER 1 CONCEPT AND REGULATORY FRAMEWORK OF STOCK SPLITS IN INDIA The pace of economic growth and development of any country depends upon its sound financial system. Financial system promotes savings and investment in the economy and enlarges the resources flowing into the financial assets which are more productive than the physical assets. Financial market has significant role to play in this context because it is a part of the financial system. It provides the financial resources needed for long term and sustainable development of different sectors of the economy. Financial Market is divided into Money Market and Capital Market, Money Market refers to the open market operations in highly marketable short-term debt instruments whereas Capital Market deals in long-term debt issues and stocks. Capital market is one of the significant aspects of every financial market. The capital market is the barometer of any country s economy and provides an effective mechanism for the capital formation. It aids the transfer of private earnings into business investments and thus provides much needed liquidity to the investors. The primary market and secondary market are the two segments of capital market. There are constant fluctuations in the prices of securities in the stock market. The management often took the decision to conduct a stock split if the price of that particular stock reaches too high. It is believed that the stock split brings the share price to an optimal trading range and makes it affordable for the small investors. The stock split has been selected as a subject matter of the present study and the effect of stock splits are analyzed in detail. The present chapter of the study is attributed towards introduction of Indian stock market and basic concepts related to stock splits in India. This Chapter has been divided into four sections. Section - I exhibits the introduction and growth of Indian capital market. Section - II describes the basic concept of stock splits, various theories and justifications for stock splits. Section - III describes the regulatory framework of stock splits in India. 1

2 SECTION - I INTRODUCTION & GROWTH OF INDIAN CAPITAL MARKET 1.1 Introduction to Capital Market The capital market may be defined as an organized mechanism for effective and efficient transfer of money from the investing parties to the entrepreneurs engaged in the business either in the private or public sectors of an economy. In simple words, Stock Market is a market where the trading of company stock, both listed and unlisted securities takes place. It is different from stock exchange because it includes all the national stock exchanges of the country. Capital market is one of the most vital components of a free-market economy, as it provides the companies with access to capital in exchange for giving the investors a slice of ownership in the company. Capital market makes it possible to grow the small initial sums of money into large ones. At the same time, it also provides security and confidence with respect to the investment involved. In the past decade, the capital market witnessed a number of extraordinary developments. The procedural aspects of trading and the variety of instruments traded on stock exchanges have been improved. The Capital Market is divided into two segments: a) Primary Market b) Secondary Market Growth of Indian Capital Market Indian capital market is one of the oldest stock market in Asia with an uninterrupted history of well over three centuries. It dates back to the 18 th century when the main institution involved in trading of shares was the East India Company. In 1830 s the main dealing in the shares and stocks (mainly in bank and cotton) was initiated in Bombay. There after the concept of broker business was started which attracted a number of people by the mid of 18 th century. In 1860, there were 60 brokers trading in various items. The 'Share Mania' in India began when the America stopped supplying cotton to the Europe due to civil war broke in America. Further the number of brokers increased to 250. At the end of the war in 1874, the market found a place in a street (now called Dalal Street). The informal group of stockbrokers organized themselves as the The 2

3 Native Share and Stockbrokers Association which, in 1875, was formally organized as the Bombay Stock Exchange (BSE). In 1956, the Government of India recognized the Bombay Stock Exchange as the first stock exchange in the country under the Securities Contracts (Regulation) Act. Thereafter, National Stock Exchange (NSE) was established in 1992 as the first demutualized electronic exchange in the country. NSE was the first exchange in the country to provide a modern, fully automated screen-based electronic trading system which offered easy trading facility to the investors spread across the length and breadth of the country. The past two decades in many ways have been remarkable for the Indian capital market. The market has grown exponentially in terms of resource mobilization, contribution of household sector in the capital market, number of stock exchanges, number of listed stocks, market capitalization, trading volumes, turnover and investor s base. Along with this growth, the profiles of the investors, issuers and intermediaries have changed significantly. 1.2 Indian Primary Capital Market Most companies are usually started privately by their promoters. However the promoter s capital and the borrowed capital from banks or financial institutions might not be sufficient for running the business over the long term. That is when corporate and the government looks at the primary market to raise long term funds by issuing securities such as debt or equity. Primary Market is also known as the new issue market. It is the market for issuing new securities. In the primary market the securities are purchased directly from the issuer, which is not in the case of the secondary market. These securities may be issued at face value, at premium or at discount. The primary market is where new issues are first sold through initial public offerings (IPOs). The issuer may be a new company or an existing company. After trading in the primary market the securities will enter in the secondary market. Growth of Indian Primary Capital Market Primary market segment of capital market has great significance because finance, the lifeblood of industry is mobilized specially through primary market. The primary market enables the corporate sector in mobilization of resources through different instruments like equity shares, preference shares and debentures/bonds. It helps the public and private sector companies in arranging the finance mainly for their 3

4 new projects, expansion, modernization, acquisition etc. This market facilitates mobilization of resources from public issues (through prospectus), right issues (through letter of offer) and through private placement. The primary market enables the government as well as corporate sector in raising the capital to meet their requirements of capital expenditure and to discharge the other obligations. The resources that are raised by corporate sector and the government from Indian primary market are presented in the Table 1.1 and Chart 1: Table Resource Mobilization from Indian Primary Capital Market (Rs. in billions) Issuers Corporate Securities Govt. Securities Amount % of Total Amount % of Total Total , CAGR (in %) 13% 16% 15% Source: ( ISMAR 2001 to 2014) The table 1.1 indicates that Indian primary market in corporate securities as well as government securities really picked up in the past decades. The total resource mobilization from the Indian market was Rs billion in which increased by five times to Rs billion in but declined thereafter to Rs billion in Next year trend got reversed and the amount mobilized started increasing and approached to Rs billion in During the period to , there was a steady increase in resources mobilized which took a major turn thereafter and increase at a faster pace. There is a compound annual growth rate (CAGR) of 15 percent in total resources mobilized during the period. The major contribution to this mobilization was made by the government securities market. 4

5 The proportion of government securities in the total mobilization amounted to Rs billion (61 percent of total) in , which increased to Rs billion (i.e. 74 percent of the total) in but decreased thereafter to Rs billion (54 percent of total mobilization) in which again increased to Rs billion in the year The CAGR of government securities has been 16 percent during the period from to Chart 1: Resource Mobilization from Indian Primary Market The resources raised by the government sector from central government as well as state government securities are depicted in the Table 1.2: Table 1.2 Resource Mobilization by Government Sector Issuers Central Govt. % of Total State Govt. % of Total Total CAGR (in %) 15% 21% 16% Source: ( ISMAR 2001 to 2014) 5

6 The central government has the major share in resources mobilized from Indian primary capital market. The primary issues of the central government have increased by seven times during the period from to i.e. Rs. 996 billion (87.9 percent of the total govt. issue) in and Rs billion (78 percent of total) in During the same period, the primary issues of the state governments ranged from Rs. 137 billion (12 percent of total) to Rs billion (21.9 percent of total) and had been showing a CAGR of 21 percent. The resources raised by the corporate sector from domestic as well as international markets are presented in the Table 1.3: Table 1.3 Resource Mobilization by Corporate Sector Issuers Domestic issues % of Total Euro Issues % of Total Total , CAGR (in %) 13% -22% 13% Source: ( ISMAR 2001 to 2014) Due to global financial crisis, the total resource mobilization because of corporate securities decreased by 31 percent in , i.e. from Rs billion in to Rs billion in Resource mobilization through the euro issue route has also dipped by 82 percent during as compared to However, the resource mobilization by the government securities increased by percent i.e. to Rs billion in from Rs billion in This can be attributed to government s measures taken to counter the effect of global financial crisis on the Indian economy. 6

7 1.3 Indian Secondary Market The primary market deals with the new securities whereas the outstanding securities are traded in the secondary market, which is commonly known as the stock market. It is a market, in which an investor purchases a security from another investor rather than the issuer, subsequent to the original issuance in the primary market. It is also called aftermarket. The participants in secondary market include both institutional and individual investors. Secondary market is a mechanism, which provides liquidity, transferability and continuous price formation of securities to enable investors to buy and sell them with ease. The investor would not invest in any instrument if there was no medium to liquidate the position. The secondary markets provide an efficient platform for trading of the securities initially offered in the primary market. Trading in the secondary market is done through stock exchange. The stock exchange is a place where the buyers and sellers meet to trade in shares in an organized manner. The stock exchange performs the following functions: Provide trading platform to investors and increase liquidity of the shares Ensure safe and fair dealing Facilitate listing of securities Dissemination of information Aids in financing the industry Self-regulating organization A comprehensive legal framework was provided by the Securities Contract Regulation Act, 1956 and the Securities and Exchanges Board of India Act, A three tier regulatory structure comprising of Ministry of Finance, the Securities and Exchanges Board of India and the Governing Boards of Stock Exchanges regulates the functioning of stock exchanges in India. There are two ways to describe the general conditions of the stock market: it can be a bull market or a bear market. A bear market indicates the continuous downward movement of the stock market. Conversely, a bull market indicates the constant upward movement of the stock market. A particular stock that seems to be increasing in value is described to be bullish while a stock that seems to be decreasing in value is described to be bearish. 7

8 The bull and bear terms do not refer to the short term fluctuations in the stock market. A bear market is the stock market wherein the prices of key stocks have fallen by 20 percent or more over a period of at least two months. Prices, even during a bear market, may temporarily increase. Bull markets, being the opposite of bear markets, indicate a rise in the prices of the key stocks over a certain period of time. Growth of Indian Secondary Market Secondary Market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the stock exchange. Listing on stock exchanges enables the shareholders to monitor the movement of share prices in an effective manner. There are constant fluctuations in the stock market and sometimes the stock price quotations vary significantly throughout the day. The growth of Indian secondary market from the period to is presented in the Table 1.4: Year Table 1.4 Growth of Indian Secondary Market Some Indicators No. of Listed Companies Shares Traded Turnover (Rs. Billion) 8 Close Price (SENSEX) Close Price (NIFTY) Source: The stock market in India has grown considerably during the period to Table 1.4 and Chart 2 showed that the turnover, which is an indicator of market liquidity, has shown a sustained increase from the year to

9 The market turnover on BSE was Rs billion in which increased by five times to Rs billion in However, it decreased to Rs billion at the end of year thereafter approached to Rs billion in the year Next year trend got reversed and turnover again start decreasing. There has been a decrease of percent over the four years from to Chart 2: Market Turnover Table 1.4 and Chart 3 indicates that the Bombay Stock Exchange s Sensitive Index (Sensex) was around Rs at the beginning of the 21st century, it segued between several crests and troughs during the decade and settled at Rs at the end of The union budget of 1999 brought cheers to the market. The Sensex stimulated up to in the year The trend got reversed during which witnessed large sell-off in the worldwide securities market and deceleration in the growth of domestic economy. This brought down the Sensex to at the end of Chart 3: Movement of Sensex and Nifty 9

10 It is clear from the chart 3 that there have been steep rise in the prices of securities from to as compared to the period to The Sensex in the year was Thereafter, Sensex reached at its peak to during and closed at (i.e. multiplied 2.5 times). The market recorded continuous improvement from to and thereafter sharp decline in share prices. In the year , the Sensex came down at only. In , Indian capital market recovered again and Sensex reached new high levels and closed at which took downward turn in early In the year 2012, the prices of securities start increasing and Sensex closed at in the year (table 1.4). The chart 3 revealed that the CNX Nifty followed the same trend as that of Sensex. It increased from in the year to in the year After the above discussion it can be concluded that the Indian capital market has witnessed significant structural changes in the past two decades. The growing number of market participants, reduction in transaction costs, significant improvements in efficiency, transparency and safety, and the level of compliance with international standards have earned for the Indian market a new respect in the world. SECTION II CONCEPT AND EVOLUTION OF STOCK SPLITS It is easier to make money during bull markets. In a bull market, all dips are temporary and going to be corrected any time soon. Since the upward rising of the prices cannot go on forever, the investors need to sell their stocks when the market reaches its peak. Companies also tend to split their shares in this phase to make them affordable for small investors. A stock split is a corporate action that increases the number of corporation's outstanding shares by dividing each share. Stock splits have confounded financial economists for years because they merely increase the number of outstanding shares without providing any new funds to the company and without changing the shareholders claims on firm s assets. Stock splits remain one of the most popular and least understood phenomena in equity markets. 10

11 1.4 Concept of Stock Split A stock split is a decision by the company s board of directors to increase the number of outstanding shares by issuing more shares to the current shareholders. For example, in a 2-for-1 split, every shareholder with one share is given an additional share. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after a 2-for-1 split. The stock s price is also affected by a stock split. After a stock split, the stock price will be reduced since the number of outstanding shares has increased. In the example of a 2-for-1 split, the share price will be halved. Although the number of outstanding shares and stock prices change, the market capitalization remains constant. A stock split is a procedure that increases or decreases a corporation s total number of outstanding shares without altering the proportionate ownership of existing shareholders. The balance sheet items remain same except that the total number of outstanding shares of company increases proportionately to the ratio of split. The most commonly used split ratios are 2:1, 10:1, 10:2 etc. Stock splits are basically a form of stock distributions that are typically classified into two main categories: small stock distributions (less than 25 percent), and large stock distributions (greater than 25 percent). Gathered from cumulative research over the years, most small stock distributions are accounted for as stock dividends and large stock distributions are accounted for as stock splits, but this estimation is not completely valid, especially for large stock distributions. Managers of corporations have a choice of using their preferred accounting method, but the firms paying small stock dividends are required by law to account for the distribution by transferring the value from retained earnings to the contributed capital accounts (common stock and paid-in capital). However, corporations do choose their own methods in accounting for the large stock distributions. According to Craig Peterson and James Millar, management of a corporation may select one of the three different methods in accounting for large stock distributions: - Stock split method - firm proportionately decreases the par value of common stock and increases the outstanding common shares. Retained earnings method - firm transfers the value from retained earnings to the common stock account. 11

12 Paid-in capital method - firm decreases paid-in capital and increases common stock. Thus, stock splits are simple paper transactions with high administrative costs and have no effects on the company s future earnings. Types of Stock Splits There are different types of stock splits that can have different effects based on the reasons they are implemented. Some of the concepts to understand about this technique are literal stock splits, reverse stock splits and dividend payouts: - 1. Literal stock splits: Because of the existence of reverse splits, it is necessary to differentiate between the two. For example, a literal stock split occurs when a company announces that it will do a 2-for-1 split of their common stock. If ABC Industries has 1,000 shares of public stock at Rs. 50 per share before a 2:1 split, they will have 2,000 shares of public stock at Rs. 25 per share after. 2. Reverse stock splits: Reverse stock splits are less common and have a somewhat negative investment strategy attached to them. If the price of a stock drops too low, many mutual funds will not purchase them and they even run the risk of being de-listed, or removed from the market indexes. In addition, the low stock prices create a psychological stigma as people view them as worthless. By doing a reverse stock split, companies can raise the stock price by lowering the number of outstanding shares, eliminating the problems caused by the low stock prices. 3. Dividends payouts: Sometimes a company will choose to avoid a stock split and lower the share prices by paying a stock dividend to shareholders. The effect of this move is somewhat the same as a split in that it lowers the share price since the company is worth less after the payout. This can be a good investment philosophy for companies that already have a large number of available shares plus the move is usually well received by stockholders, since this is basically investing a portion of the profits back into the people that have already invested in the company. 1.5 Theories for Stock Splits Surveys show that managers justify stock splits on the basis that they improve liquidity and marketability of the shares. Every year, there are several stock split events taking place and most board of directors mention the similar reasons as to why they have decided to split their stock. Also, the empirical researches in corporate finance indicate that the stock splits are a positive occurrence and that they are 12

13 indicative of a company s positive future performance. Furthermore, empirical research has also documented several negative consequences of the stock splits, such as increased volatility, larger bid-ask spreads and increased transaction costs following a stock split. Two popular theories have been developed in the financial literature to explain why the stocks behave this way. The signaling hypothesis argues that managers use stock splits to encourage private investors to gain confidence in the firm s future, whereas the liquidity hypothesis argues that managers use stock splits in order to increase trading volume by bringing the share price down to a more affordable level. The liquidity hypothesis is very intuitive, but the increase in trading volume does not fully explain the positive price reaction of the stock on the announcement date. The signaling hypothesis is less intuitive, but it may provide the explanation for the abnormal returns. Though several studies have been conducted in the developed economies, testing the impact of stock split on different market parameters, there has been handful of the studies on the subject in Indian market. One such study by A. K. Mishra (2006), taking the span of , concluded a negative effect on the price and return of the stocks. This finding is contrary to the several other studies in the developed economies, such as U.S., Spain, Canada etc., where positive relation was established between stock splits and stock returns. There are several theories which have attempted to explain why, despite creating no value on paper, stock splits tend to impact the share price and trading volume: Signaling Theory According to signaling hypothesis, in a scenario of asymmetric information between managers and investors, managers may use stock splits to signal positive information to the market about the firm s future expectations. The rationale is that executives will only proceed with a stock split if they believe that the firm will do well in the future. Managers obtain relevant information about the future because of their expertise in making operating and investment decisions. The signaling theory also states that the investors tend to view a stock split as a positive signal for the firm s future prospects and will tend to purchase these shares, thus creating a rise in the stock price. 13

14 Fama, Fisher, Jensen & Roll (1969) theorize that management decides to undertake a split if it believes that the future dividends of the company will be higher. First formalization of the signaling theory, however, has been put forward by Grinblatt, Masulis, and Titman (1984) in their research as a possible explanation of the excess returns observed around split announcement and split ex-dates. The study hypothesize that a management team with preference for a specific price range for its stock may choose the timing of a stock split in order to reveal private managerial information regarding future stock returns. The presence of positive abnormal returns around the stock split announcement in many empirical studies, (Asquith, Healey and Palepu, 1989; Ikenberry and Ramnath, 1996; Mukherji, Kim and Walker, 1997), provides evidence for the signaling hypothesis Optimal Trading Range Theory According to the optimal trading range theory, stock splits are used as a tool to realign the share price to a desired price range so that it is more affordable for the small investors to buy round lots of shares. This states that the investors, either consciously or subconsciously, seek out stocks that trade within a certain range. If a stock passes the upper limit of this range, many times the company will declare a stock split to once again bring down the share price to the optimal range. This optimal trading range is largely psychological, as investors with limited amount of investment funds would prefer to receive more shares than fewer, even though the amount invested would be the same. The idea is widely supported by the practitioners that stock splits are intended to keep the price of shares within some optimal trading range. Specifically, small investors are penalized by high stock prices that deny them the economies of buying stocks in round lots. On the other hand, wealthy investors and institutions will save brokerage costs if securities are priced high because of the fixed per share transaction cost. Therefore, the argument that there exists an optimal price range that equilibrates the preferences of these classes of investors holds. Managers interested in a broad and heterogeneous stockholder base may strive to adjust stock prices to such an optimum range by splitting their stock or distributing stock dividends. A survey of manager s motives for stock splits conducted by Mehta, Yadav and Jain (2011) revealed that 98.5 percent of the respondents indicated that splits 14

15 make it easier for small investors to purchase round lots, and 88.2 percent believed that splits keep a firm s stock price in an optimal range and increase the number of stockholders Self Serving Management and Dispersion of Control Theory A possible explanation for stock splits claims that a self-serving management prefers a diffused ownership since small investors can not exercise much control over the company and a stock split would likely achieve this. However, on the contrary studies done by experts [Maloney & Mulherin (1992) and Baker & Powell (1993)] show that management dispersion hypothesis does not hold. Their results show that stock splits accompany increases in institutional ownership for firms. It seems that the shareholder base of a company subsequent to a split expands, yet the theory of self-serving management that aims to reduce overall institutional ownership does not hold as the empirical results disprove this theory. The evidence against this theory is too strong. By stock splits management reaches the goal of more diversified clientele, yet this does not mean that the splitting firms end up with a more diffused shareholder base Increased Liquidity Theory One of the most prominent theories regarding stocks splits is that these are positive actions. In spite of the fact that the investors do not make money from stock splits, an equally prominent theory regarding stock splits is that companies employ this tactic to enhance liquidity. The empirical research conducted on stock splits also shows that the companies split their stock to achieve greater liquidity. In the liquidity enhancement theory, the assumption is that companies with shares that trade close to or well into triple digits become inaccessible for many investors. As only fewer investors are participating in the company, the more constrained liquidity can become, so some companies will engineer a stock split to boost liquidity. Past literature has attempted to measure changes in liquidity around stock splits by analyzing the changes in some parameters, such as trading volume, relative bid-ask spread, number of shares traded and number of trades, from pre split period to post split period. The evidence for the liquidity hypothesis is mixed. Muscarella and Vetsuypens (1996); Desai, Nimalendran and Venkataraman (1998); Menendez and Gomez-Anson (2003) observed an increase in trading volume during the post-split period, and hence provide support for the liquidity hypothesis of stock splits. On the 15

16 other side, Conroy, Harris and Benet (1990); Ferris, Hwang and Sarin (1995) indicated that the corporate liquidity decreases rather than increases after the execution of split. After analyzing the above theories it can be concluded that the following points best explains the results of stock splits - a) Signal: Management team of an exceptionally well performing company with private information regarding the future performance of their firm decides to split the company s shares. This signal has its own benefits and costs. The benefits of the signal are - o This signal may benefit the firm if it is accompanied with an announcement that declares futures dividends will be larger, or that the company, if it was not paying dividends up to that point, will initiate giving dividends. o The firm may be benefitted from the signal if the company went through a previous split event. The market would expect the company s stock to split to the post-split price level of the previous split event. If the split factor is bigger than this expected level future expected returns are even higher. The signal is costly to the firm. There are two cost components: o Relative bid-ask spread increases due to the split and this results in higher order processing costs, which in turn reduces liquidity. o Pre-split shareholders incur higher aggregate costs resulting from per share based commission costs. b) Promotion: After splitting the shares, the number of outstanding shares increased which leads to increase in per share based commissions and order processing costs. Following the split, the market-maker has a lot to gain from increased trading. As a result market maker heavily promotes the stock split to add new clientele. c) Enlarged Clientele Base: With more coverage prospective shareholder buys the stock, based on the management team s signal and the market maker s information dissemination in order to reap the benefits of excess returns surrounding split announcement and split ex-dates. Prospective shareholders expect that these excess returns will not be negated in the year subsequent to the split ex-date. 16

17 Furthermore prospect further diversifies their portfolio with non-negative long-run excess returns. Prospect can be a small investor or an institutional investor, but in most likelihood, is a small investor. d) Increased Number of Trades: The company s shareholder base is enlarged; management has more diversified clientele making their jobs more secure. Furthermore the management has solidified the gains of the exceptional return period with this new clientele base. Shareholders earn excess returns around the announcement and ex-dates and this return will continue for longer periods. At the same time the number of small shareholders increases so does the number of small trades and aggregate number of trades. However, due to the increase in number of trades stock return volatility also goes up around the stock split event. As the split is costly, this signal has value over the year following the split thus the number of trades in the subsequent year doesn t decrease. 1.6 Need for Stock Splits The companies take all the trouble and costs to carry out the stock split. Therefore, the question arises as to why companies resort to stock splits? As such, stock splits world over have puzzled researchers who tried to find out possible explanations for such actions. Over the years, enough evidence has been gathered to show that this so called cosmetic change appears to enhance the value of the firm, as positive abnormal returns are witnessed at the announcement and execution of stock splits. Empirical research has shown that the market generally reacts positively to the announcement of a stock split [Foster and Vickrey (1978), Woolridge (1983), Grinblatt, Masulis and Titman (1984), McNichols and Dravid (1990), Bar-Yosef and Brown (1977)] which would imply that the announcement of splits are actually carrying financially relevant information about the company s performance. Baker & Gallagher (1980) interviewed 100 chief financial officers of firms listed in New York Stock Exchange and their primary justification of the stock splits was to achieve better trading range in order to attract more investors. The theory simply argues that low trading price attracts more investors, therefore reducing trading costs and increasing the trading volume of the stock. A stock split is usually done by the companies that have seen their share price increase to the levels that are either too high or are beyond the price levels of similar 17

18 companies in their sector. The primary motive of stock split is to make shares seem more affordable to small investors even though the underlying value of the company has not changed. There are several reasons companies consider while carrying out this corporate action: - Affordability - During a bull run, a lot of mid-cap and small-cap stocks are chased by retail investors and market operators. Typically, retail investors chase price and not value. The idea of doing a stock split is to make stocks more affordable to them. Stock splits are frequently prompted when the company s stock price has risen to a level that corporate management feels is out of the popular trading range. At that point, it ceases to be a frequently traded stock and is generally traded only by high net worth investors and institutions. If this happens then the trading volume decrease and investor interest subsides. To overcome this, management declares a stock split. Psychological Effect - Another reason for splitting the stock is psychology. As the price of a stock gets higher and higher, some investors may feel the price is too high for them to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more attractive level. The effect is purely psychological. The actual value of the stock doesn t change a bit, but the lower stock price may affect the way the stock is perceived and therefore lure new investors. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before, and of course, if the prices rise, they have more stock to trade. Performance Indicator - Companies usually tend to split their shares when the company has an optimistic view of its future operations. The announcement of a stock split can be a symbol that the stock has attained a certain level of success. The fact that a company has a record of multiple stock splits usually indicates that the company is among one of the faster growing firms, since their stock has been split numerous times. Liquidity - Another reason for splitting a stock is to increase a stock s liquidity, which increases with the stock s number of outstanding shares. When stocks get into the thousands of rupees per share, very large bid/ask spreads can result. By splitting the shares a lower bid/ask spread is often achieved; thereby increase in the liquidity position of company. 18

19 Increase in Market Price of Share - A stock split is often seen as a positive indicator that a company is growing. Companies that split their stocks have typically enjoyed a big jump in share prices. However, just because a company declares a stock split, it does not mean that the stock price will inevitably rise in reaction. There are many other variables that influence investor s decisions in the result of a stock split including economic reports, market stability, earnings, interest rates, external conflicts, etc. Broadening of Shareholder Base - Companies also split their shares if they want to broaden their shareholder base and make more shares available to the investors. The more a stock has been split, the larger the quantity of individual shares that exist. This potentially allows a wider number of people to own the shares. On the other hand, the more people own the stock, the more a company can potentially be protected from government regulations. A motivation for stock split could also be the company s defense to a potential hostile takeover. Current literature has studied the reasons for splitting the stocks, to a large extent, from the perspectives of management teams (board of directors) and market makers. This is so because shareholder s approval for stock split decisions is generally not needed as the split is affected as a stock dividend and in most cases the number of shares outstanding after the split is still below the maximum number of shares authorized by the splitting company s shareholders. Almost always only board of director s approval is necessary and enough. Thus, most theories trying to explain the reasons for stock splits are management centric. 1.7 Implications for Stock Splits There are plenty of arguments over whether a stock split is an advantage or disadvantage to investors. One side says a stock split is a good buying indicator, signaling that the company s share price is increasing and therefore doing very well. Due to stock split, the high priced stocks will be available at lower rates. The small investors can easily afford to buy stocks of low price. There is also a probability that after stock split; the stock price may go up as more investors may rush to buy stocks at lower rates. This may be true, but on the other hand, one can t get around the fact that a stock split has no affect on the fundamental value of the stock and therefore poses no real advantage to the investors. While stock split is an important tool in the hands of 19

20 company managements for enhancing shareholder wealth, some promoters may misuse the facility to mislead investors and prop up stocks prices artificially. 1) Affordability of Each Share is Improved - Splitting the stock brings the share price down to an attractive level. Generally, a company is also motivated to split their stock to attract more investors with a lower share price. However, some people can only buy lower priced stock because they may not have the buying power to make a larger investment. Thus, they wait till stock splits so that they can afford some shares. 2) Growth Indicator - A stock split is often seen as a positive indicator that a company is growing. Companies that split their stocks have typically enjoyed a big jump in share prices. Some investors incorrectly conclude that the frequency of stock splits speaks to a company s future prospects. 3) Improves Liquidity - The high-priced stock tends to be illiquid due to the psychological reasons and transaction cost. Therefore, when the price climbs up to a certain level, the executive will split the stock to lower the price to facilitate trading. Due to the lower prices, there will be more investors willing to buy and therefore the companies build up more liquidity by splitting their stocks. 4) More Number of Shares Than Earlier - Splitting a stock gives the existing shareholders the feeling that they suddenly have more shares than they did before, and of course, if the prices rise, they have more stocks to trade. The current shareholders enjoy the pleasure of doubling or tripling the number of shares. Consequences 1) Easier Sell - The lower price stocks are psychological easier for shareholders to sell. As share prices rise, investors perceive the value of each share as being great. They also tend to associate a high price with successful company management and growth. Once share prices drop after a split, more impulsive selling is common. 2) Record Keeping - Over time, stock splits create record-keeping challenges for company accountants, analysts and shareholders. When a stock split is done, there is quick drop in the share price. This doesn t offer fair assessment of the value of a company s stock. Fortunately, advanced software tools make it easier for companies and investors to show split adjustments. 3) Low Price Risks - Normally, companies split their stocks when things are going well and the share price is on the rise. However, an overly aggressive split may 20

21 lead to some risks if the share price falls too much going forward. A company whose share price grows from $5 per share to $20 per share in two years may decide to do a 2-for-1 split. This puts each share at $10. If the economy and company fall on hard times, the share price could drop below $5. This can make share less attractive to large investors. 4) Costs Stock split is not free of cost for the company. Stock splits result from either a board of directors meeting and decision, or a vote of shareholders. Either approach has costs. Also, the company must meet listing exchange and legal requirements by letting shareholders know of the date and effects of the stock split. Written notification letters and mailing them out to all shareholders gets costly for companies with a lot of owners. 5) Listing Requirements: To be listed on a stock exchange stocks must maintain a certain minimum price per share. If a company splits its stock and then value of company itself falls, the shares may fall below this requirement and can be delisted from stock exchange. However, in the current market scenario stock splits have little significance as the minimum market lot now is just one share. In the earlier days when the minimum market lot was 100 shares or 50 shares, stock splits made a difference in respect of the investor s capability to buy high priced stocks. SECTION - III REGULATORY FRAMEWORK OF STOCK SPLITS IN INDIA 1.8 Regulations Regarding Stock Split A Secondary Market Advisory Committee (SMAC) was formed by SEBI under the leadership of Dr. R. H. Patil to fill the loopholes in the existing structure. This committee has to advice on the matters related to Indian stock market. The committee has deliberated on the following issues: - o Frequent change of face value of shares by listed companies o Frequent change of names by listed companies. The meeting of committee held on October 9, 2003 discussed with many other things, the issue of frequent changes in face value of shares by listed companies via 21

22 splitting or consolidation and recommended modifications in the provisions of SEBI which was declared on June 14, Background 1. The equity shares of listed companies were originally required to be offered to the public in uniform denomination of nominal value of Rs.10/-. This nominal value of Rs.10/- was referred to as par value of shares and provided benchmark for determining premium and discounts. The Ministry of Finance, vide Circular No. 1/7/SE/81 dated Jan 22, 1983, had stipulated that equity shares which are in denominations other than those of Rs. 10/- or Rs. 100/- should be converted into Rs.10/- or Rs.100/- before Dec 31, In 1999, it was decided to do away with the concept of fixed par value of Rs. 10/- and give freedom to the companies to issue shares in denomination, to be determined by them in accordance with the provisions of the Companies Act, The consideration behind the decision were as follows: - o It was felt that in many cases, the net worth of the companies did not justify the minimum face value of Rs. 10/- and with a subsequent decline in the stock prices of the company, the investors had to suffer a loss. o The dispensing with the par value concept of shares and giving the companies an option to fix the minimum face value for their equity shares would enable valuation of companies by their real net worth. o The investors also would be benefited as they would not be forced to pay an artificially higher price for the shares. o Such a measure would help increase the investor base and thus deepen the market. 3. Accordingly, SEBI vide circular no. SMDRP/Policy/Cir-16/99 dated June 14, 1999, modified the Central Govt. circular no. 1/7/SE/81 dated January 22, 1983, and provided for the following: - o The companies were given the freedom to issue the shares in any denomination to be determined by them in accordance with Section 13(4) of the Companies Act, However, these shares would not be issued in decimal of a rupee. o The companies which seek to change the standard denomination may do so after amending the Memorandum and Articles of Association. 22

23 o The existing companies which have issued Rs. 10/- or Rs. 100/- may also change the standard denomination into any denomination other than decimal of a rupee by splitting or consolidating the existing shares after amending their Memorandum and Articles of Association. o Only those companies whose shares are dematerialized shall be eligible to alter the standard denomination. It has since been observed that many companies thereafter have split the face value of their shares. While this splitting is in accordance with the provisions of the circular, it was observed that several companies were resorting to frequent splitting and consolidation, within a short span of time. Such frequent changes have caused confusion amongst the investors as to whether the market price of the shares is based on the pre-split or post-split or post-consolidation. The analysis and comparison of the movement of share prices of such companies with those of other companies in the similar sector, becomes difficult. Further, as dividend is also declared as a percentage of face value of the shares of company, frequent changes of the face value of shares by way of stock split and consolidation results in the investors being often misled by a high dividend rate and also creates confusion in the calculation of return/payout from the company. The practice of frequent splitting and subsequent consolidation of the face value of shares is not a healthy practice and runs contrary to the spirit of the circular. Rather than being a facilitating measure to help the investors and increase the depth of the market, such splitting goes against the interest of the investors. Recommendations The following modifications in the provisions are recommended: - a) The listed company with an average market price of less than Rs. 500 per share in the previous six months is not allowed to split its shares. b) If the company has gone in for split or consolidation, it would not be permitted for a repeat split or consolidation of its shares within a period of three years from the date of the last split/consolidation. c) The information of split or consolidation, as the case may be, will have to be circulated through the websites of stock exchanges and through Electronic Data Information Filing and Retrieval System (EDIFAR) for a period of one year, from the date of split or consolidation. 23