February 17, 2003	Monday	Zul Hijjah 15, 1423

Stock split, as the name implies, means subdividing the outstanding shares. For instance, if a company has 10 million shares outstanding, then a 2 for 1 split would turn them into 20 million shares. Each shareholder would have two shares for every one share held before the split.

Generally, the motivation behind splits is to improve the liquidity of the stock, so that investors can easily buy and sell the stocks at the prevailing price. If a stock were very high priced, then buying even a small lot would require significant investment. This may reduce liquidity in the share and also affect the price discovery because the price of a liquid share is more likely to be its fair value than that of an illiquid share.

High prices can also influence shareholding pattern. They can keep small investors from buying stocks. For instance, share of Unilever trades for more than Rs1,000. At this price, buying 100 shares would cost at least Rs100,000. The daily turnover of Unilever is less than 10,000 shares or Rs10 million. If Unilever went for a 20 to 1 split, then its stock price should come down to Rs50, and it is likely that its turnover would improve. Facilitating small investors to take position in their stocks is unlikely to be a priority of the listed companies, but it certainly does top the agenda of the overall capital market reforms.

We are not suggesting that price of a stock is the sole or even a dominant determinant of liquidity. Liquidity and shareholding pattern usually depend on a number of factors, including the size of the company’s market capitalization, number of shares available to general public (free float), investor interest, the quality of corporate governance. However, keeping other things constant, a split can improve liquidity.

Stock splits vs bonus issues: A bonus issue differs from a split in two ways. First, the bonus is a slow way of doing what a split can achieve very quickly. A 2-for-1 split equals a 100 per cent bonus. The second difference between the two is their varying impact on the financial statements, as shown in Table 1. While a bonus issue turns reserves into paid-up capital, a split does not change the reserves. Moreover, due to increase in paid-up capital bonus issue can raise regulatory levies, such as the listing fees.

Both, however, tend to reduce the EPS, which concerns some financial managers. But the EPS again is an accounting and not an economic number, so it should not be driving an economic decision. Economically, both should not increase the share price. If you divide a cake into smaller pieces, it does not increase the size of the cake and if you divide the value of a company over a large number of shares, it should not increase the value of the company.

You can say that by having smaller trading lots for high priced stocks and larger lots for low price stocks, the problem of liquidity can be addressed. This is the usual practice. The KSE uses six different lots as shown in Table 2.

So are stock splits desirable even though the exchanges can have different trading lots to cater for liquidity, and splits should not add economic value for the shareholders? The answer is still yes.

Splits and complexity: Splits are still desirable because having multiple market lots creates complexity in processing information in public offers, trading, clearing, settlement, and record keeping. If we had only one market lot for all, say of 500 shares and multiples thereof, then no additional work or capacity would be required in the systems to process any other lots. At the KSE, almost three fourth of the turnover happens in stocks with lots of 500.

Complexity increases costs, which have to be borne by someone. The stock exchange and the Central Depository Company recover their costs from the brokers, while the brokers recover these costs from the investors. Eventually, it is the investor who pays. The costs of complexity usually escape notice because they are hidden, spread out over a large number of investors. We don’t know what portion of the bill would not have been there had the system been simple. But we do know that bill could have been lower if the system were simpler.

Clearing and settlement of all the shares in the Central Depository Company is being taken over by the National Clearing and Settlement System of the National Clearing Corporation. That is, we would have one clearinghouse for all three exchanges — the Karachi Stock Exchange, the Lahore Stock Exchange, and the Islamabad Stock Exchange. Having a single market lot of 500 shares would help reduce the complexity in the National Clearing Corporation System.

Legal framework for stock splits: The stock splits can be carried out under Section 92(1)c of the Companies Ordinance, 1984. The section reads: “A company limited by shares, if so authorized by its articles, may alter the condition of its memorandum so as to subdivide its shares, or any of them, into shares of smaller amount than is fixed by the memorandum.” This is subject to the usual condition that the rights attached to the shares must remain the same before and after the division. Under 92(3), the company can exercise the powers conferred by 92(1) only in a general meeting. The law also allows reverse splits or share consolidation under 92(1)b subject to the same conditions.

The Central Depository Company’s regulations also allow share splits under Chapter 8D “Consolidation or Sub-division of Securities”. The regulations of the exchanges are silent on the issue of splits. Clearly, the legal framework for stock splits is in place and it is not cumbersome either.

Bringing about stock splits: So far there hasn’t been any case of a listed company splitting its shares. Ironically, there has been one case of reverse splits, i.e. share consolidation of Indus Dying & Manufacturing Limited, listed at the KSE. Why is that? We are of the view that splits have not happened because having adequate liquidity in their stock is not a significant concern of the management in our corporate sector.

Since operational complexity creates hidden costs, exchanges and National Clearing Corporation have also not been vocal in making a case for standardization of market lots and share splits.

Splits change the par value. The concept of par, however, has already been made obsolete in a number of jurisdictions because of its economic irrelevance. It should not be a consideration in bringing about stock splits.In the absence ofsufficient incentive for the corporateto go for the split,the exchange should make splits mandatory through its regulations once a stock meets pre-specified criteria.

Criteria for splits: The regulatory criteria for mandatory splits should include price, free float, and investor interest in a stock. There are 25 companies listed at the KSE, which have a price above Rs100 as of January 22, 2003. These include: the Unilever, the PSO, the Shell, the Pakistan Oilfields, the Wyeth, etc. In our opinion, a price above Rs100 is on the higher side. In some of these stocks investor interest and free float are virtually non-existent. Increasing or decreasing their market lots would not influence their liquidity or encourage entry of small investors. The exchanges can simply bring their market lots to multiples of 500 without bothering about splits.

One can say that if we are going to have a market lot of only 500 shares, then splits should be made such that every existing shareholder gets a market lot. For instance, if some one subscribed to only 100 shares at the time of their public offer, then raising the market lot to 500 would turn these lots into odd lots, which cannot be traded on the main board. Selling an odd lot is difficult and usually an investor has to pay a discount from the prevailing price to be able to sell it. Either the investors with odd lots would have to bear some costs for the benefit of investors at large or odd lots would have to be facilitated.

Conclusion: Splits benefit investors at large because they can improve liquidity of a share. They also facilitate small investors in investing in stocks in which they would not in the absence of split. More importantly, splits reduce complexity at the exchanges by helping standardize the market lots. Since the listed companies are unlikely to initiate splits, the exchanges should make splits mandatory using a pre-specified criteria.