Stock splits: Are they worth it?

Investors follow many different investing and trading strategies. One of them involves the now ubiquitous ‘stock split’. A stock split often triggers, as our study shows, buying interest in a stock. The reason is probably that there is a psychological gain in terms of a rise in the number of shares owned. But those who are familiar with ‘numbers’ know that a ‘stock split’ is just a book entry that does not result in any benefit in terms of earnings per share.

As you are aware, announcing stock splits is becoming a rage among corporates. In the US, stock splits are very common. They serve the purpose of raising liquidity without increasing the company’s equity servicing burden (as overall equity capital remains same). Also, stock splits, increase the affordability of a stock, thereby permitting greater participation from retail investors.

In India, until recently, bonus issues were hugely popular with investors, who used to treat it as a sign of a company’s strong fundamentals. However in case of bonus issues, the equity capital of a company (in absolute terms) increases. This then had implications associated with bloated equities.

But the general question in the minds of investors is “Why stock splits?” Stock splits add no value but increase the number of shares in the ratio of the split. While the split may be for diverse reasons, companies that split their shares repeatedly tend to have certain common attributes. They are usually industry leaders, generating fantastic returns.

The best examples of stock splits are Infosys, Zee and Satyam (TMT giants). Those who invested pre split in these stocks have seen their wealth grow dramatically. Of course, the split was not the only reason, but it definitely contributed to it. So while the act of splitting may not add value (in terms of say earnings per share), investors tend to believe that stock prices of fundamentally sound companies rise after a split. Stock splits generate an excitement in the market resulting in price appreciation in anticipation of the announcement.

Here, we discuss the examples of Indian companies that have gone for a stock split and the impact on stock prices post split.

The above table throws up a very interesting picture. Of the ten companies that we studied, eight posted gains in the one month prior to the split. One may argue that other factors could have driven interest in the stocks. But given the fact that these companies announced splits at different times, the view that a split leads to enhanced interest in the stock does hold some weight. The enhanced interest is partly speculative, though. Of the ten stocks, six recorded moderate to significant losses in the month post the stock split. This was probably due to the fact that short-term investors were booking profits. (For a more accurate impact of a stock split on the share price, pre and post split, however, a more scientific study would be in order).

A number of companies who split their stock end up with higher market capitalization. Stock splits make the stock affordable even to retail investors, thus driving buying interest. Also, liquidity is enhanced which could drive the interest of large funds/investors.

Companies looking to join the stock split bandwagon?
As we understand, among the prominent companies HCL Technologies, Mastek, Dabur, Colour-Chem, ITC and Abott Laboratories are the ones set to board the stock split bandwagon in the near future.

What should be your investment strategy?
The general trend suggests that to reap the maximum benefit, an investor must exit partly, immediately after the split becomes effective. This will enable an investor to preempt selling from short-term investors and speculators. Otherwise, an investor may witness erosion in the value of his holding, as short-term investors who bought stock on the announcement of a split take to booking profits.

In case of long term investing, which is a preferred investment strategy, investors do not need to concern themselves with a movement that results largely from such technical factors. What should matter to them are the fundamental strengths of the business. And over the long term, that is probably the only thing that matters.