Do bonus issues really make you wealthier? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Do bonus issues really make you wealthier? 

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In this issue:
» Poor statistical skills pose challenge to India's recovery
» High debt companies likely to get disappointed despite the rate cut
» Are markets over reacting to positive quarter results?
» ...and more!


00:00
Bonus! The word has a very positive connotation, implying something extra or some gains at no cost.

Most of us react to it with a positive surprise. And stock markets are no different. Whenever a listed company announces a bonus, one can see a surge in the company's stock price. A recent instance of this can be seen in case of shares of HCL Technologies. On the news of the Company's Board to consider bonus issue, the stock has witnessed a spurt in volumes of around 1.32 times and has opened 6% up today. Before we share our views on such reactions, let us first understand what a Bonus issue implies.

Bonus issue is a corporate activity wherein existing shareholders are issued further shares in a ratio as announced by the company. While the existing shareholders do not pay for these 'extra' shares, these are not 'free' as they are generally perceived to be. What happens through this process is that a certain value is transferred from the reserves to the equity capital of the company. The same reserves which are already owned by shareholders! Ultimately, there is higher liquidity. But, no change in the proportionate stake in the company.

It is noteworthy that a company uses its free reserves - left after keeping aside the funds for reinvestment, for this bonus issue. While the latter leads to better liquidity, it does not suggest any tangible gains for shareholders. Since bonus issue leads to an increase in the outstanding shares, the per share metrics - book value, earnings, dividends etc and share price, all get adjusted (downwards) depending upon the ratio that the company has announced.

It is obvious that a bonus issue does not guarantee improved fundamentals for a firm. Then, why do stock prices soar up on the basis of such announcements?

It is the media hype breeding wrong perception about bonus issues, that they increase shareholders' wealth, that can explain this anomaly. While there is nothing wrong with the practice of issuing bonuses, investors' ignorance about its actual implication leads to speculative trades.

This may lift the stock price in the short term; however, there is no addition to the stock's intrinsic value which is based solely on fundamentals.

In fact, in some cases, the unscrupulous management may exploit this ignorance make such announcement to artificially inflate the stock prices. Unfortunately, for such naive investors who buy into a business hoping to gain from such corporate activities, the price is paid in the form of a loss when the hype dies down and the market once again wakes up to the long term fundamentals of the firm under consideration. As such, investors would do well not to fall for such gimmicks and base their investing decisions on fundamentals and growth prospects of a company.

Do you get tempted to invest in stocks based on corporate announcements such as bonus or stock splits? Let us know your comments or share your views in the Equitymaster Club.


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01:30   Chart of the day
Big reforms are likely to sway the Indian economy with the rise of Modi Government in power. A lot of these changes have already taken place. However, there is one big challenge in the way of any reforms that not many are taking notice of.

No matter how good a doctor is, if you go with a wrong diagnostic report, the treatment is unlikely to work for you. The challenge that Indian policymakers are facing is something similar in nature.

What we are referring to here is the lack of up to date and inaccurate data. It is unfortunate that this data that forms the basis of policy making is unreliable and does not always reflect the true picture. As mentioned in an article in Mint, unlike other economies where data mining and presentation is getting polished over the years, India seems to be going from bad to worse in this regard. Even the economists agree that the volatile data for some of the key official parameters such as factory production defies economic logic. The Chart of the Day highlights another such instance. As you can see, there is a huge divergence between two sources - National Sample Survey's (NSS) and National Accounts Statistics' (NAS) estimates on consumption expenditure in India. In the last four decades, the difference in the estimates has gone up from 5.5% to 51%! No wonder the expectations regarding a particular parameter - such as inflation, are so out of tune with the actual inflation data. So even as Government takes big steps in the direction of reforms and policy change, it needs to first ensure that it gets the foundation right.

Deteriorating data mining to jeopardize policy making process
*NSS and NAS stand for National Sample Survey and National Accounts Statistics respectively

03:00
The much awaited rate cut is here. It is expected to be a shot in the arm as far as India's recovery is concerned. India Inc, stock markets, public, Government - all have cheered the move, with Sensex gain of around 728 points testifying the same. However, as high debt profile of India Inc. poses a challenge for the economy and financial system, the companies with weak balance sheets may not get access to cheaper funds as easily as they had in the past.

With RBI tightening the noose on banks with poor asset quality, banks are now required to make enough provisions for bad assets. As highlighted in an article in Mint, this has limited their ability to give fresh loans. With more focus on better risk assessment , the balance has shifted in favour of the banks. And no wonder they are reluctant to lend to companies that have disappointed in the past. While high debt companies do have option to raise funds from abroad or from NBFCs, these are likely to come along with difficult covenants and higher cost of funds respectively. While this may imply some pains for high debt companies, we believe it is well deserved. As far as investors and banking system are concerned, both stand to win from increased focus on credit discipline along with low interest rates.

04:00
The earnings season for December 2014 has kick started with quite a few frontline companies announcing their results. While some of these have reported performance better than expected, we are quite amused by the way the stock markets are reacting to the same. A case in point is the stock of Wipro Ltd. The stock has opened up 8% , cheering the results announced post market hours on Friday. It makes us wonder if the stock markets are being irrationally exuberant, just looking for an excuse to gain further momentum.

As more companies announce results, we will not be surprised to see the stock markets over reacting to interim financial performance of the companies. While we would be glad to see a strong financial performance by India Inc,. it will be with a sense of caution. Investors too should understand that a good performance in one quarter is not going to change the fundamentals and hence long term valuations of a company. Hence, they would do well to follow a disciplined investing approach and not get distracted by the noise in the markets.

04:30
The Indian stock markets continued to trade in the positive territory after opening the day on a positive note. At the time of writing, the benchmark BSE Sensex was up by 140 points (0.5%). Barring FMCG and software sectors, the sectoral indices were trading in the green with the stocks in the healthcare and consumer durables space leading the gains. Barring Hong Kong and China, the Asian equity markets were trading mainly in the green with markets in South Korea and Japan leading the gains. The major European markets have opened on a mixed note.

04:56  Today's investing mantra
" I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett
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9 Responses to "Do bonus issues really make you wealthier?"

Girish

Jan 22, 2015

Can it be explained with a simple example ? Are bonus shares issued to shareholders who are holding the shares for certain time e.g One year + or so.

Like (2)

jay shah

Jan 22, 2015

Theoretically the writeup makes sense. Bonus is my gratification vs my co's wealth. Mkts are more driven by sentiments & psycology of participant masses/volume traders rather than small section of informed traders.Hence
bonus expectations offer good opportunty to mkt players.

Like (2)

N.H.Pandurangi

Jan 22, 2015

I fully agree with the contents of the article. To preserve cash resources and to please the investors companies can issue bonus shares instead of dividend which involves depletion of cash.

Like (2)

kanakasabhai

Jan 20, 2015

Not entirely true. When companies like Infosys, TCS declare bonus shares it reduces cost of shares ex. bonus, increases liquidity and allows people to buy more thus increasing demand and price. Good managements declare more quantum of dividend post bonus and some even maintain dividend on post bonus capital after a year or two. If bonus is declared by a good company and followed up generally with good results, people gain buying cum bonus. Recently infosys that has given over 10% on ex. bonus.

Like (2)

RK77

Jan 20, 2015

Nice article on Bonus Shares. I guess we are conditioned to run after what appears to be free. This failing of mankind is exploited by the marketing experts when they offer 'Buy one Get one free' or its variants. While it is true that bonus shares temporarily bring down various ratios like EPS etc., they also unlock wealth held in reserves. If the fundamentals of a company are strong it will continue to earn and is able to increase the wealth of individual share holder in due course of time as all the parameters revert to pre-bonus levels. More number of shares means more dividend in the long run. E.g. CASTROL and COLGATE. However, in a company with weak fundamentals a bonus issue does not benefit the shareholder and only helps speculators and manipulators. E.g. IVRCL

Like (2)

prakash kukarni

Jan 19, 2015

yes,I do get tempted by a bonus/stock split. WHATS UR TAKE ON THE FORTHCOMING TATA COFFEE STOCK SPLIT.should I buy NOW ?

Like (5)

sharad

Jan 19, 2015

Your posting does not deal with the issue of Bonus Issues being used for booking short term losses to set off against Shortd Term gains made on other shares.
Please explain if it is a fact or a myth

Like (2)

Ratnakar Shetty

Jan 19, 2015

People may use the bonus for other matters such as for booking short term capital loss to offset shorter term capital gains. Capital gains are calculated on FIFO basis. When bonus shares are received cost is zero and the old shares value is halved (if 1:1 bonus is made). The old holding can be sold at a short term loss on FIFO basis to offset any other short term capital gains. The new shares at zero cost can be sold after 1 year at no capital gain.

Like (2)

Ragini Ghanekar.

Jan 19, 2015

If the bonus shares are issued out of reserves, it certainly adds value. Instead of giving cash back to share holders they are paid in the form of extra shares.

Like (2)
  
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