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B. Venkatesh

THE proposal for a 10-for-one stock split by TVS Motors brings to the fore the stock market reaction to such corporate decisions. Empirical evidence suggests that stock splits generate excess returns following the announcement.

Logically, stock splits should not carry the same significance as they did when there was the concept of a market lot for trading in stocks. The price impact of stock splits may nevertheless persist in the current context, because of investors' preference for price zones.

Affordability: In the past, companies primarily engaged in stock splits to make the price more affordable to the retail investors.

Take TVS Motors. The stock currently trades at Rs 900. The initial investment would be Rs 90,000 if one assumes a market lot of 100 shares. That is, indeed, a sizable amount to invest in one stock for a retail investor.

A 10-for-1 stock split should theoretically bring the stock price down to Rs 90 per share. A total investment of Rs 9,000 for a market lot of 100 shares should make more investors buy TVS Motors.

Now, more demand for the stock will eventually push up prices, resulting in the excess returns post-split. This explanation is logical when we had the concept of market lot. At present, however, a retail investor can buy just one share of a stock. On this count then, stock splits are a redundant corporate action.

Signalling effect: Various research studies have suggested that the excess returns post-split may be due to the market perceiving this as a positive signal from the company management. But this explanation may not be quite tenable in the current milieu because of the increased regulatory and voluntary disclosure practices.

Companies are more candid now in their communication to the shareholders than in the past.

Technology companies, for instance, use earnings guidance to inform the market about their expectation of future performance. Since this is not common practice in the manufacturing sector, these companies may still use stock splits as a positive signal. There is, however, one problem with this explanation.

Stock splits per se may be a positive signal, but what will the market conjecture from the split ratio? Will a 5-for-one stock split mean a less positive outlook for the company than a 10-for-one split? Perhaps, investor psychology is the primary reason for companies deciding for stock splits in the current scenario.

Price zones: Typically, investors prefer to buy shares in lots of 100 or 50. There is no sanctity in this number. Perhaps, it is a legacy of the era of pre-determined market lots. So, even if retail investors can buy just one share of highly priced stock, not often do they purchase such a small quantity.

Suppose a retail investor buys ten shares of TVS Motors at Rs 900 per share. If the stock moves to Rs 950, the investor will receive Rs 500. That is, indeed, a small profit, without considering brokerage and demat charges. But for argument's sake suppose TVS Motors trades at Rs 90 after the stock split, and the investor buys 100 shares. If the stock moves to Rs 95, the profit is still the same (Rs 500). Yet, investors are likely to feel more content buying 100 shares and taking profit of Rs 500 than buying just ten shares.

Add to this the psychology that investors may be comfortable with "price zones". To give an example, an average middle- class person may find Rs 250 a very high price for a pizza, but may buy it if quarter its original size is priced at Rs 75. The person may not mind paying a premium to get the quarter-sized pizza, perhaps, because Rs 50-100 is his price-zone for pizzas.

In the same way, retail investors prefer stocks trading within their desired price-zone. And stock splits bring more stocks in the desired price-zone.

That could, perhaps, explain why investors may still be willing to assign higher PEMs to such stocks, even though we do not have the concept of market lot anymore. Stock splits may not, therefore, be a redundant corporate decision.

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