Signalling Hypothesis and Clientele Shifts: Evidence from Indian Stock Splits

Abstract

Researchers have always questioned the rationale for stock splits. Some have attributed the existence of stock split to a manager’s desire of increasing the liquidity of the stock. Others have argued that the split is a mechanism by which managers can signal to the market the expectations of future profitability of the firm. In this study we test the signalling hypothesis of stock splits and its implications on institutional holdings in Indian markets. We examine if the splitting firms exhibit significant increases in net sales and profitability after the split. Further we examine if splits have a significant effect on the ownership pattern on individual and institutional investors like FIs and FIIs. We find strong evidence supporting the signalling hypothesis in the Indian markets. There are significant increases in net sales and profitability of splitting firms after the split as compared to control firms. Also, consistent with the signalling hypothesis, FII shareholdings increase significantly for splitting firms. Thus, through splits, Indian managers tend to send signals to the market about the expected future profitability of the company. Also, financial institutions like Foreign Institutional Investors (FIIs) have the ability to process these signals effectively.