The Hindu Business Line : Stock splits not money for jam

If you have been keeping an eye on company announcements looking for buying opportunities, you would surely have noticed the almost instant positive reaction to news of a stock split or bonus.

Despite the market's bullish reaction , these corporate actions are wealth-neutral. After all, a stock split is nothing more than a case of getting two fifties in exchange for your Rs 100 note.

Stock split

Essentially, if you have 10 shares of face value of Rs 10 each, you will have 50 shares of Rs 2 each if a company puts through a 10-to-2 stock split. When a company splits its stock, you have more shares but of a lower denomination. So the value of your holdings should remain unchanged.

Bonus issue

In the case of a bonus, the company converts a part of its accumulated profits into capital as an alternative to paying out cash dividends.

A 1:1 bonus, for instance, would entitle you to one share for every share you hold. The equity base of the issuing company expands in this case , unlike a split where it remains the same.

But here too, the market price corrects to adjust for the expanded equity base. In theory, a stock's market price should halve for a 1:1 bonus or fall to a tenth of its original value in a 10-to- stock split.

But in practice, the market price, after a stock split or a bonus, often settles higher than the theoretical value.

This is because splits and bonuses tend to improve liquidity in a stock as there are more outstanding shares floating around in the market.

Investor psychology also tends to favour stocks that are more "affordable"; they are willing to buy 100 shares of Rs 20 each rather than buy 10 shares of Rs 200 each.

Price adjustment

In part, it is the expectation of this investor behaviour that drives the strong price action before a stock goes ex-split or ex-bonus (when price adjusts to reflect the split or bonus move). Business Line's analyses, too, have found that significant price action accompanies a stock split or bonus announcement, especially in a bull market. Stocks often settle at a higher level than the theoretical price on the ex-bonus/split date in a majority of the cases.

Sounds like money for jam? Not quite. Remember that in most cases, the momentum cools off in the weeks that follow the ex-date. Timing your entry and exit will also not be easy. Sometimes the run-up before the split is so sharp that valuations become stretched, resulting in the stock settling at a lower level on the ex-date.

Picking a winner

If you buy into a stock with the expectation that higher volumes post-split or bonus will attract greater trading interest, make sure it is a stock of a company that is fundamentally sound. Sometimes companies of obscure background with poor trading volumes tend to split their stock to attract buying interest.

Check if volumes will indeed get a boost from the split or bonus. A stock that has an average trading volume of 3,000 shares is hardly going to attract significant institutional interest, at a volume of 6,000 shares.

Finally you can catch a stock split or bonus well before it happens by latching on to a good growth stock. Stock splits usually follow strong price action and not the other way around. Similarly, only companies with really strong growth prospects can afford to service a large equity base that is created through bonus offers. Imagine if you had picked Infosys at the time of its public offer. You would have received five bonuses by now.

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