Information content and policy implications of stock splits, new evidence from the saudi arabian capital market

... permission of the copyright owner Further reproduction prohibited without permission Information Content and Policy Implications of Stock Splits: New Evidence from the Saudi Arabian Capital Market. .. consisting of the minister of finance and national economy, the minister of commerce and industry, and the governor of the Saudi Monetary Agency The purpose of this research is to study the impact of. .. the market response to the announcement of the new policy and the magnitude of abnormal returns surrounding the announcement date The study then investigates whether the policy appears to have information

INFORMATION CONTENT AND POLICY IMPLICATIONS OF STOCK SPLITS NEW EVIDENCE FROM THE SAUDI ARABIAN CAPITAL MARKET

Information Content and Policy Implications of Stock Splits: New Evidence from the

Saudi Arabian Capital Market

A dissertation submitted in partial fulfillment

of the requirements for the degree of

Doctor of Philosophy

By

Ali Mofarreh Ali Serhan

May 2005

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© 2005 by Ali Mofarreh Serhan All Rights Reserved

This dissertation is honorably dedicated to my parents.

ACKNOWLEDGEMENTS Above all, all praises and thanks are due to Allah, the most merciful and the most gracious, the lord of mankind, who blessed me with his guidance, boundless bounties, ample mercy, and endless help and support I am sincerely very thankful to him for his favors upon me in my life and throughout my educational journey In him I trust.

My parents deserve a special and sincere acknowledgement for keeping their hearts attached to me and my family overseas Without their permanent support, patience, concerns, and constant prayers, I would not be able to attain my goals

During my academic journey that ultimately led to finishing this dissertation, there were many people who have made significant contributions to its success, and they deserve acknowledgement and appreciation I am highly indebted to my dissertation advisor and committee chair, Professor Carolyn M Callahan, for her profound insights, constructive ideas and valuable inputs, encouragement and support, concern about me and my family, and professional mentorship not only in my dissertation stage but also during my entire doctoral program I am also grateful to the other members of my dissertation advisory committee, Professor Gary D Ferrier, and Professor Rodney E Smith for their valuable inputs, encouragement, and support

Though words are truly inadequate in capturing her real sacrifice, my wife, Nourah, deserves sincere thanks and great appreciation for her tireless support, assistance, patience, and sharing my pleasure and my pressure My dissertation would have never been accomplished without her Sincere thanks also go to my children Adel, Abdulkareem, Sarah, Hassan, Omar, Malik, and Yunis for their patience and sympathy

My gratitude goes to my brothers, sisters, and the rest of my broad family members and friends, who permanently were very concerned about me and my family Their support and prayers for me are appreciated.

Finally, I am also appreciative and thankful to all the staff of the Accounting Department at the Walton College of Business, especially the head of department, Professor Karen Pincus, for their help and support

TABLE OF CONTENTS

ACKNOWLEDGEMENTS v

1 INTRODUCTION 1

2 MARKET OVERVIEW 4

2.1 Historical Glance of the Market 4

2.2 Market Growth 6

2.3 Market Structure & Performance 10

2.4 Trading Process 13

2.4.1 Types of Trading Orders 18

2.4.2 Trading Commission 19

2.5 Market Indexes 20

3 THE SPLIT POLICY AND ITS IMPORTANCE 21

4 LITERATURE REVIEW AND THEORY 23

4.1 Information Content of Stock Splits 24

4.1.1 Stock Split Decision Incentives 25

4.1.1 a Signaling Hypothesis 26

4.1.1 b Trading Range Hypothesis 28

4.1.1 c Liquidity Hypothesis 30

4.1.1 d Survey Research on Stock Splits 31

4.1.2 Factors Determining the Market Response to Split Announcements 32

4.2 Stock Changes around Stock Split 36

4.2.1 Ownership Structure 36

4.2.2 Volatility Changes 37

4.2.3 Number of Trades, Turnover, and Volume 37

5 THE FIRST STUDY 38

5.1 Hypotheses Development 38

5.2 Research Methodology 39

5.2.1 Study Sample Selection 39

5.2.2 Data Collection 40

5.2.3 Research D esign 41

5.3 Analysis and Results 43

5.3.1 Sample Characteristics 43

5.3.2 Discussion 51

5.3.3 Results 61

5.4 Sensitivity Tests 63

6.2 Research Methodology 68

6.2.1 Study Sample Selection 68

6.2.2 Data Collection 68

6.2.3 Research Design and Model Specification 69

6.3 Analysis and Results 72

6.3.1 Sample Characteristics 72

6.3.2 Descriptive Statistics of Model V ariables 81

6.3.3 Correlations 83

6.4 Regression Analysis and Discussion 86

6.4.1 Statistical Issues 86

6.4.1.a Outliers 86

6.4.1.b Multicollinearity 86

6.4.1 c Heteroskedasticity 87

6.4.2 Tests of Hypotheses 87

6.5 Sensitivity Tests 92

6.6 Conclusion and Implications 92

7 THE THIRD STUDY 93

7.1 Hypotheses Development 93

7.1.1 Ownership Structure 93

7.1.2 Number of Trades, Turnover, and Volume 94

7.2 Research Methodology 95

7.2.1 Study Sample Selection 95

7.2.2 Data Sources 96

7.2.3 Research D esign 97

7.3 Analysis and Results 98

7.3.1 Sample Attributes 98

7.3.2 Tests of Hypotheses and Discussion 107

7.3.2.a Ownership 107

7.3.2.b Trading Volume I l l 7.3.2.C Number of Trades 115

7.3.2.d Turnover 118

7.4 Conclusion and Implications 121

8 LIMITATIONS 122

9 CONTRIBUTION 122

REFERENCES 124

1 INTRODUCTION

“A stock split (or forward split) is an event in which the firm decides to divide each share of stock into multiple shares Conversely, a reverse stock split is an event in which a number of shares is combined into one new share” (Wu and Chan 1997) In traditional theory, stock splits can be considered merely cosmetic changes in the equity that have no economic significance to shareholders However, empirical research does not support this theory as stock split announcements are associated with positive abnormal returns The impact of stock split signals and their implications on share returns and other investment aspects have been the focus of financial researchers for three

decades as evidenced by the large body of accounting and finance literature associated with stock split issues

The accounting and finance literature repeatedly documents a market reaction to stock splits The literature also provides plausible explanations of the motives driving firms to initiate stock splits One of the explanations provided is that stock splits serve as

a device to signal private information known by managers to market participants and other interested parties (Brennan and Copeland, 1988) and (McNichols and Dravid,1990) Another explanation suggests that firm managers intend to maintain the stock price at a “preferred” or “optimal” trading range (Lakonishok and Lev 1987), whereas Brennan and Hughes (1991) and Ikenberry et al (1996) suggest that stock splits cause investment analysts and dealers to reevaluate their firms and discover the private information conveyed by managers (dual purpose) The financial literature also reveals the factors that play a significant role in determining the magnitude of information

environment characteristics, including the degree of information richness in the trading environment.

This study extends the literature on stock splits to an international stock market, the Saudi Arabian capital market It investigates a unique stock split policy urging publicly traded firms to split their par values two-for-one This policy was adopted on December 14,1997, by the Ministerial Committee for Share Trading Supervision (MCSTS), a governmental committee consisting of the minister of finance and national economy, the minister of commerce and industry, and the governor of the Saudi

In this research, decreeing stock split is empirically found to be associated with information content However, evidence gathered shows that the market reaction is mixed, not in one direction Some firms reacted positively (CAR=2.11%) considering the split

decree as good news, while some other firms reacted negatively (CAR= -2.55%) considering

it as bad news At the sector level, the cement industry is the only industry that demonstrates positive cumulative abnormal returns On the other hand, banking, manufacturing, and service sector, in general, demonstrated negative cumulative abnormal returns Surprisingly, agriculture and electricity sectors demonstrated no reaction No evidence that sectors differ in their reactions is found Further, the magnitude of abnormal returns is not associated with share market price

Examining the determinants of the market reaction to decreased stock split reveals that only firm size and the book to market value ratio are significant Firm size is

positively related to the market reaction, while book to market ratio is negatively related

to market reaction These results imply that as the size of a firm increases, the magnitude

of abnormal return associated with the market reaction to the decreed stock split increases, while as the book to market value ratio of a firm increases, the magnitude of abnormal return decreases The impact of firm size is greater in magnitude than that of book to market ratio

Finally, the stock split policy has attained some of its intended goals First, there

is no empirical evidence that the total number of shareholders increased by the implementation of the policy Dissimilarly, volume is found to increase significantly for some firms and decrease for other firms in the market Similarly, number of trades is also found to increase significantly for some firms and decrease for other firms in the market However, turnover, generally, has declined after the split It can be concluded that the

execution of stock split has dual effects These results have important implications for

both policy makers and investors as they suggest that a stock split policy has differential market effects that may be industry specific.

The remainder of this dissertation consists of eight sections Section 2 provides an overview of the Saudi stock market, while section 3 presents a detailed description of the stock split policy enforced by the Saudi government Section 4 furnishes a brief review of previous stock split literature and provides a theoretical background for all three papers’ research hypotheses Section 5, section 6, and section 7 are devoted to discuss separately each study of the research papers of the dissertation Each section presents research hypotheses, methodology, analysis, and findings for each of the three respective studies Section 8 reports the caveats that could limit the scope of the results Finally, section 9 indicates the incremental contribution made by conducting this research

2 MARKET OVERVIEW

2.1 Historical Glance o f the Market

The first Saudi joint stock company, the Arab Automobile Company, was established in the mid 1930’s There were about 14 stock companies in 1975 In the late 1970’s, the number of large publicly traded companies and joint venture banks increased due to Saudization1 of foreign banks and the rapid economic expansion During this period, major initial public offerings were made to generate the required capital for these new firms

In 1984, a Ministerial Committee, consisting of Minister of Finance and National Economy, Minister of Commerce, and Governor of Saudi Arabian Monetary Agency

(SAMA), was formed by a royal decree to develop and set the standards, regulations, and rules that promote the market operations SAMA was delegated and charged with the day-to-day regulation and supervision o f the capital market Share-trading intermediation was also restricted to commercial banks since they operate under the umbrella of SAMA

in order to facilitate and improve the regulatory framework Accordingly, commercial banks established the Saudi Share Registration Company (SSRC) for the purpose of providing central registration facilities for joint stock companies and settling as well as clearing all shares trading transactions occurring in the market An automated clearing and settlement system was introduced in 1989 via sophisticated computer systems The Electronic Securities Information System (ESIS), which was developed and operated by SAMA, was also introduced to the market in 1990 in order to provide market participants with all trading information such as bid-ask share prices, number of trades, volume, , and daily market index Moreover, ESIS was developed to enable investors to enter their buying or selling orders and to follow up their status

In October 6, 2001, “Tadawul,”2 the second electronic generation of securities trading, clearing, and settlement system was launched to replace the old system (ESIS)

“Tadawul” is a highly sophisticated computer system It allows electronic trading accounts for all investors and provides depository service of traded shares This system also permits selling and buying several times during the day, along with other advanced capabilities Tadawul thus integrated the ESIS daily trading system with that of SSRC for clearing and settlement into a comprehensive electronic system with more powerful capabilities

2.2 Market Growth

The market growth in capital, number of transactions, volume, and Riyal’s value

of traded volume increased significantly Between 1990 and 1997, the year in which stock split was adopted by the government, market capitalization increased by 130%, and the all share index also increased by 99.8% Volume also increased by 1747%,

transactions by 441% and value of traded shares by 1309%

In contrast, between 1990 and 2003, those market indicators have increased dramatically Market capitalization has increased by 508%, the all share index by 352.9%, volume by 32641%, transactions by 4327%, and value of traded shares by 13300% Table 1 depicts market growth in these indicators between 1990 and 2003, showing the gradual year- by- year growth in the market

TABLE 1Development in Market Indicators 3

Year Transactions

(thousands)

Shares Traded (millions)

Value of traded shares (billions)

MarketCap.(billions)

All Share Index

The number of transactions has grown year after year from 85000 in 1990 to460,000 in 1997 and eventually to 3,763,000,000 in 2003 The graph on Figure 1 reflects the steadfast growth in the number of transactions, and the huge jumps that happened in

happened in year 2002 and 2003

The value of traded shares grew as the volume in the market grew This value grew from SR 4.403 billions in 1990 to SR 62.06 billions in 1997, with an increase of approximately SR 58 billions (1309 %) Furthermore, the value increased more between

1997 and 2003 to SR 596 billions with an increase of approximately SR 534 billions from the value in 1997 (860 %) The historical growth in the value of traded shares is depicted

in Figure 4

FIGURE 4Growth in the Value of Traded Shares

Value of Traded Shares

2.3 Market Structure & Performance

The Saudi capital market is the largest capital market in the Middle East It operates in the largest economy in the region It consists of seven sectors: banking, manufacturing, cement, services, electricity, agriculture, and telecommunications sector, which has been launched recently with new two telecommunications firms

As of December 31, 2003, the total number of listed firms in the Saudi capital market was 70 firms that are distributed among the market sectors The banking sector includes 9 national banks The manufacturing sector includes 24 companies The cement sector includes 8 companies The service sector includes 18 companies The

telecommunications sector included one company The agricultural sector includes 9 companies Finally, the electricity sector includes one large company that came into existence from merging several working electricity companies in all provinces of the country

At the end of 2003, based on Tadawul 2003 report, the entire market capitalization was approximately SR 590 billions The largest sector by market capitalization is the banking sector, which at the end of this year was capitalized at SR176.2 billion, 30% of the total market capitalization The second largest sector by market capitalization was the manufacturing sector with SR 134 billions, 22.73% The

telecommunications sector occupied the third with SR 126.83 billions, 21.5% The fourth sector in capitalization was the electricity sector with SR 84.4 billions, 14.3% o f market capitalization The Cement, service, and agricultural sectors occupied the fifth, the sixth, and the seventh respectively, with SR 43 billions (7.3%) for the cement sector, 23 billions (4%) for the service sector, and 2.5 billions (0.42%) for the agricultural sector

In terms of transactions, the number of transactions executed in the market during

2003, based on Tadawul report, was 3.8 million transactions The most active sector was the service sector with about 1.22 millions transactions, 32% of total transactions

executed in the market The least active sector was the cement sector with about 109 thousands transactions, 2.9 % of transactions executed in the market

The volume traded in the market during 2003, based on the same previously mentioned report, was approximately 5.6 billion shares The most active sector in volume traded was the service sector with about 2.3 billion shares, 41% percent of volume of the entire market, whereas the least active sector with respect to volume traded was the banking sector with approximately 87 million shares, 1.6% On the other hand, the value

of shares traded in the whole market was approximately SR 596.5 billions where the manufacturing sector had the biggest stake in this value by attaining SR 171.55 billion in

value traded, 28.8 % of the market traded value The least sector in value traded was the agricultural sector with 8.5 billions, 1.4% of the market.

The total number of outstanding shares of the entire market as of December 31,

2003 is 2,347,147,371 common shares The largest sector in number of shares was the electricity sector, which had about 833.318 million shares, 35.5% of the total number of shares in the market The least sector in number of shares was the agricultural sector with

36 million shares, 1.5 % of the total number of shares in the market

During the fiscal year of 2003, the total earnings attained for all listed firms in the market added up to SR 18,991.85 millions, the portion of each market sector was as follows:

The banking sector SR 8.259 billions, 43.4% of the market earnings The manufacturing sector SR 3.671 billions, 19.3% of the market earnings The cement sector SR 2.171 billions, 11.4% of the market earnings

The service sector SR 276.83 millions, 1.4 % of the market earnings The electricity sector SR 1.077 billion, 5.6% of the market earnings The telecommunications sector SR 3.545 billions, 18.66% of the market earnings The agricultural sector SR -10.09 millions, a mixture of some gains and some losses

The banking industry is, therefore, the most profitable sector in the market, followed by the manufacturing industry and the telecommunications industry

Shareholders’ equity at the end of 2003 for the entire market reached SR 182.8 billions The distribution of this amount across market sectors makes the manufacturing sector at the top of all sectors with SR 48.05 billions, 26.3% of the market The banking sector is second with SR 43.2 billion of shareholders’ equity, 23.6% of the market equity

The third sector is the electricity sector with shareholders’ equity of SR 42.8 billions,23.4 % o f the market equity The telecommunications sector, service sector, cement sector, and agricultural sector follow in terms of shareholders’ equity respectively.

The dividends distributed to shareholders for the year 2003 by the entire market were SR 11.348 billions The banking sector alone distributed SR 6.4 billions, the largest dividends among market sectors This amount represents 56.4 % of the total market dividends The least sector in dividend distribution was the agricultural sector with dividends of only 13.75 millions

In 2003, Earning per share (EPS) ranged from SR 41.05 to SR 5.51 for the banking sector In the manufacturing sector, the range of EPS was from SR 16.78 to -S R 7.53 The cement sector had a range of EPS of SR from 35.56 to SR 5.63 EPS of the service sector ranged from SR 19.73 to SR -14.12 The electricity sector had EPS of SR 1.97 as it consists only of one large company The telecommunications sector also consists of one company with EPS of SR 11.82 Finally, the agricultural sector’s EPS ranged from SR 2.86 to SR -2.32 The banking, cement, and telecommunications sectors were the best sectors in the market in terms of EPS Furthermore, all listed firms in the three sectors generated profit In contrast, the manufacturing, service, and agricultural sector had low EPS in general with some unprofitable firms

2.4 Trading Process

The trading process in the stock market has evolved gradually with the advancements introduced to the working mechanism of the market So, if we are to understand the progress made in trading process, we need to trace back the advancements

Before early 1980’s, the stock market was informal The trading process during that period was primitive and manual For investors to buy or sell at this time, they needed to meet personally or through informal intermediaries to brokers and trade with each other the number of shares they wanted to trade The proof of ownership of shares was “certificate of shares”, which indicated the number of shares owned by an investor in the respective company The certificate was issued by the joint stock companies When a trade was agreed upon by the buyer and the seller, they or their representatives went to the company in which the shares were traded to transfer the ownership of shares from the seller to the buyer A new certificate of shares would then be issued for the buyer

including the number of shares traded Also another certificate of shares would be issued for the seller if not all of the shares in the earlier certificate of shares were sold The trading process thus took nearly a week, including the time needed by departments of shareholders relations in joint stock companies to transfer the ownership

Trading during this era was ineffective, inconvenient, impractical, and time consuming Meanwhile, it did not enable investors to trade large number of shares easily All these trading barriers drove high transaction costs

In 1984, a Ministerial committee for share trading supervision (MCSTS) was appointed by the Saudi government to include the minister of finance and national economy, the minister of commerce, and the Governor of SAMA The goal of this committee was to supervise share trading and develop the rules and regulations that govern share trading market MCSTS delegated the authority of daily trading supervision and regulations of this trading to SAMA SAMA, in its turn, established a new division, Shares Trading Control, within its organizational structure to cope with the new

delegated task In the meantime, SAMA delegated share intermediation to banking sector

“Banks are, however not allowed to buy and sell stocks for their own accounts, act as market makers, or maintain inventory for trading purposes”(Henry Azzam, 1997) SAMA delegated share intermediation to banks because the banking sector is under its direct supervision and owns a widespread network of banking branches in all over the country that can serve as the best intermediaries for share trading The decision of delegation of intermediation to the banking sector, in my opinion, is effective and efficient for three reasons First, it saved the efforts in establishing a new organizational body to be in charge of intermediation in the stock market Second, It made it easier for individuals investors to approach the banking branch nearest to them and place an order Finally, SAMA could supervise the banking sector easily in terms of intermediary activities since this sector had been under its supervision since 1952

In this stage, share trading became easier than it was in the earlier period

Investors could buy and sell through banking branches provided stock intermediation service without the burden of searching for stock owners to trade with However, the procedures of finalizing trades were very slow and manually done When a trade took place, the bank would document the transaction and send the documentation to the publicly traded firm whose shares were traded The firms then would take the necessary procedures to transfer the ownership of traded shares from the seller to the buyer and reissue a “certificate of shares” as a proof of ownership

Although some trading convenience and a somewhat formal market had been created by banking intermediary role, the trading system still had more to improve

ownership to the new owners after each transaction was impractical and ineffective for trading It delayed the process of trading and at the same time caused diversions and distraction for both the banking sector and the publicly traded companies This implied the need for a central independent depository unit Consequently, the banks, as the official intermediaries decided to establish the Saudi Share Registration Company (SSRC) to facilitate fulfillment of their intermediary role by providing central registration facilities for joint stock companies beyond settling and clearing all shares trading

transactions that occur in the market A sophisticated computer system was introduced in

1989 to handle the automated clearing and settlement process

In 1990, a big improvement was made by launching Electronic Securities Information System as stock trading system (ESIS).The ESIS is an electronic screen- based system using a central host computer in SAM A head office in Riyadh4 The host computer is connected to remote terminals located in 500 branches of all banks spread throughout the country In this new system, a bank branch receives orders from traders and submits them to its central trading unit, or dealing room There, the bank’s dealers generate bids and asks by appropriately combining or splitting orders and entering them into the central stock trading system operated by SAMA (Henry Azzam, 1997) ESIS provides several electronic handling services, including maintenance of accurate client information, liberation of bids and asks into the stock market and execution of

transactions, delivery of sold shares and money payments through SAMA clearings, and price dissemination to the central trading units of all participating banks and their branches

“The Saudi stock market’s payment and settlement systems are among the most advanced in the world For example, share settlement in Saudi Arabia is at (T + 0) and will soon move to real-time settlement (In most advanced economies it ranges between three and seven execution days)” (Henry Azzam 1997).

In spite of these huge advances in the trading process, certificates of shares ownership could not be cleared by SSRC on the same day of trading Consequently, investors could not retrade their shares in the market until they received their shares certificates, generally, the next day Furthermore, saving, organizing, and keeping track

of shares certificates after each transaction, in fact, was another constraint

In October 2001, a new sophisticated trading system “TADAWUL” was launched

by SAMA to replace the former system, ESIS TADAWUL provides trading, clearing, settlement, depository, and registration services for Saudi Arabian Securities The new system allows for straight-through-processing (STP) where 100% of all equity trades are settled instantaneously (T+0).5 In the new trading system, each investor has an electronic portfolio account against which all traded shares will be cleared and settled

The introduction of TADAWUL has increased transparency by enabling listed firms to submit their own announcements and financial statements via the internet Upon their verification, they are disseminated to the investing public, via TADAWUL website, banks, and vendors TADAWUL concentrates all trading o f local shares in one single market It also enables investors to buy and sell shares not only in banks trading rooms but also throughout internet from any place in the world The execution of trade, settlement, clearing, and payment are real time

TADAWUL eliminated the deficiencies and shortcomings found in the older system, ESIS It eliminated the need for issuing certificate of shares ownership after each transaction by immediately adding the traded shares to the electronic portfolio account of the buyer and subtracting them from the portfolio account of the seller portfolio account Additionally, it enables investors to re-trade their shares several times in the same day of purchasing Thus, the new system, TADAWUL, promotes market efficiency and

transparency

2.4.1 Types o f Trading Orders

In the new version of trading system, TADAWUL, there are ten types of orders available that can be placed by investors to achieve their investment goals of trading and

to create a reasonable level of flexibility in the market These orders as they are stated in Tadawul web site are as follows

> Hit order: An order designed to enable investors to sell the total shares they have

at the current best price available in the market

> Take order: An order designed to enable investors to buy the total shares offered

at the current best price available in the market

> Match order: This type of orders initiates an opposing order to an existing order

> Market order: It is entered to the market without price to trade a share immediately at the current best price available in the market It becomes a limit order once a price is generated automatically by the defined price protection formula

> Limit order: An order to buy and sell a specified number of shares at a specified price or better

> Unpriced order: Similar to a market order in that it is unpriced order It becomes a limit order once a price is generated by the trading system The difference

between the two is that an unpriced order is without price protection

> Undisclosed-volume order: An order with a portion of shares that is not displayed publicly An order of this type receives a price based on prevailing market

conditions Undisclosed-volume order prevents the negative influence a large-size order could play on market price

> All-or- none order: In this order, all shares must completely trade; otherwise, the order will not be executed

> Minimum block order: The order trades in the minimum number of shares specified The remaining shares are rolled in after each execution from the order

> Minimum fill order: The minimum shares must be filled before the order can trade

The TADAWUL Trading System is characterized by a high degree of flexibility

as orders are retained in the market for one day or more, a week, or 30 days If the orders are not executed within the specified time, they will automatically be cancelled It also enables investors to cancel or modify their orders at any time

2.4.2 Trading Commission

Trading commissions have been subject to a couple of changes imposed by the government regulations during the last fifteen years In October 6, 2001, a newly lower scheme of commission was implemented to stock trading This scheme states that:

> The maximum brokerage commission taken by banks is (0.0015) of the traded value A lower commission can be obtained through negotiation between investors and their banks.

> The minimum commission on trades whose values are lower than or equal SR

of market trading on a daily basis with instant reading INCEFI is a weighted average index by the number of outstanding shares in each firm in the market It also includes all listed firms in its computational process Thus it is called all shares index After the introduction of TADAWUL, the last version of electronic trading system, INCEFI was changed to Tadawul all share Index (TASI), which is merely an extension of INCEFI

Besides the all share market index, there are several sub-indexes for each market sector independently Banking, manufacturing, cement, services, telecommunications, and agriculture sectors have their own indexes, which measure market trading activities within the designated sector They are all share indexes within the listed firms in the sector In addition, they are weighted average indexes by the number of outstanding shares in firms listed within each sector

3 THE SPLIT POLICY AND ITS IMPORTANCE

On December 14, 1997, the MCSTS, which is a governmental committee consisting of the Minister of finance and national economy, the Minister of commerce, and the Governor of the Saudi Arabian monetary agency, issued a decree in which all publicly traded companies (companies listed in the stock exchange) with share nominal value (par value)6 of SR 100 are required to divide their shares’ nominal value into two shares, i.e splitting nominal values to SR 50 and consequently doubling the number of outstanding shares, besides dividing market values for each share by 2 to reflect the split Each listed company is also required by this decision to make the necessary amendments

to its charter accordingly In addition to these requirements, the new initial public offerings (IPO) must be offered in par value of SR 50 per share The committee has the supervisory power over all listed firms in the stock market, including initiating and imposing regulations and rules necessary to provide the stock market with necessary information transparency

This policy gains its distinctiveness and uniqueness for research purposes from the fact that it was not expected by either the market or firms’ managements Moreover, such a policy has never been previously issued before to enable the market to evaluate its market consequences and benefits

The declared goals of the MCSTS’ decree were to unify share par values of publicly traded firms, increase the number of traded shares (volume), expand shareholders base by making trading affordable for investors with low income in terms of

number and value of shares, and promote the depth and efficiency of stock market by increasing the number of shareholders.

In compliance with this decision, the listed companies started to take scheduled steps to respond and execute the imposed policy and adjust their accounting records to reflect the newly imposed nominal values Market values were adjusted also The process

of adjustment by each listed firm started after the end of the fiscal year 1997 by inviting the general assembly of shareholders to amend the charter

The announcement of adoption of this policy or decree may be considered a significant event and convey information content to the market This provides an opportunity to contribute to empirical literature on the adjustment of stock prices to new information, share splits The importance of the policy (signal) comes from the fact that it

is distinguishable in several features from previously similar researched signals used in studying the information content of stock splits

The first feature, which gives the signal of stock split policy its distinctiveness is that all previous stock split studies documented in empirical literature investigate stock split announcements initiated internally by firms’ management, which could announce such signals more than once a year Signals of this nature help market participants predict such announcements and act upon them Consequently, the response of the market to such signals is relatively reduced The signal of stock split policy announcement, however, reached the market surprisingly by an external party, MCSTS If this signal has information content, the response of the market to the announcement is expected to be higher than a response to a traditional stock split announcement, and the information content will be impacted literally in stock prices

The second feature is that the decree requires all firms listed in the stock market with a par value of SR 100 to adjust their par values from SR 100 to SR 50 and thus imposes a 2-for-l split of their shares The firms and the entire market received the announcement (signal) in the same way and at the same time Most listed firms held par values o f SR 100; hence the decree was applicable to almost the whole market The investigation of this particular announcement adds more reliable empirical evidence to the share split literature than the previous research where split signals were collected from different firms across time in different contextual, economic, and political settings.

The third feature is that the decree was not expected by market participants This induced a high degree of uncertainty and volatility into the market, because this signal had never been implemented by any governmental agency before, and the laws do not permit firm managements to make a market policy degree Thus, the decree is really novel and the expected leak of information to the market prior to the announcement is very low Therefore, the response of the market to the signal is expected to be higher than similar frequently repeated signals

These critical features make the signal of stock split (decree) unique compared to the other stock split announcements previously investigated in literature Furthermore, the stock split decree announcement with these unique features provides more reliable

empirical evidence than management split announcements Hence, competing hypotheses

o f a signaling effect can be eliminated

The stock split phenomenon has captured many researchers’ interests in the last

phenomenon has also triggered streams of research that cover all aspects of the phenomenon This section provides a review and a synthesis of the extant literature This provides a basis for understanding the essence of this market effect phenomenon.

4.1 Information Content o f Stock Splits

It was believed that stock splits were just cosmetic accounting changes that reduce par value and increase shares outstanding with no resultant change in stockholders’ claims in firm assets because they did not involve any additions to firms’ cash flows or change in owners’ equity Basically, the same cake is just cut into smaller slices

However, empirical studies have shown contradictory evidence to this belief by demonstrating that stock splits are not merely cosmetic, but also convey information content and economic value Statistically significant abnormal returns associated with stock splits announcements support this contention

In a seminal study, Fama et al (1969) document that stock splits are not merely cosmetic accounting adjustments to accounting records but are associated with positive abnormal returns before, but not after the stock split, for their sample of 940 splits between 1927 and 1959 Forjan and McCorry (1998) also reach the conclusion that stock split announcements are associated with higher share prices by using a large sample of firms splitting their common shares Similarly, Ikenberry et al (1996) document significant abnormal returns of 3.38 percent following split announcements Specifically, post-split excess (abnormal) returns of 7.93 percent in the first year and 12.15 percent in the first three years for a sample of 1275 two-for-one stock splits were documented This result indicates market underreaction to split announcements, as the market does not absorb the whole event and translate it into an announcement return

In terms of the studies that investigate the reaction of closed end funds to stock distributions announcements, Datar and Dubofsky (1999) find no statistical difference between the announcement day abnormal returns for closed end fund stock distributions and those of stock distributions made by “ordinary” firms More importantly, in another unique split study of American Depositary Receipts (ADR) that are not associated with splits in their home-country stock, significant positive abnormal returns between 1% and 2% are found around ADR solo-split announcements.

Similarly, in a study concerned with the reaction of the South African stock market to split announcements and capitalization, abnormal returns following splits or capitalization issues are also documented (Biger and Page 1992) Furthermore, stock splits also are associated with a positive and significant stock market response in the Hong Kong stock market (Wu and Chan 1997)

Thus, it is clearly apparent from these well-documented studies that stock splits are no longer cosmetic accounting changes, but are actually events with economic value that deserve more in-depth understanding and explanation In the following subsections, the incentives (motives) behind stock split decisions and the determinants of the

magnitude o f market response to split announcement are discussed

4.1.1 Stock Split Decision Incentives

The financial literature offers some explanations for the occurrence of stock split market effect and the incentives that drive this phenomenon There are several available explanations of the real economic effects of stock splits in the literature, including the signaling hypothesis, trading range hypothesis, and liquidity hypothesis These

explanations rely on financial market data to support each explanation In addition, there are other explanations extracted from managers’ stock splits survey research.

4.1.1 a Signaling Hypothesis

The signaling hypothesis suggests that managers possess better information about the prospects of the firms than do any outsiders Therefore, they use their discretionary financial decisions, such as stock splits, as a tool to convey private positive and optimistic information to capital market participants The signaling hypothesis thus requires

implicitly that a cost or penalty be associated with a false signal to be valid; otherwise, it

is hard to distinguish between undervalued and overvalued stocks

Szewczyk and Tsetsekos (1993) find support for this hypothesis when they find

an inverse relationship between managerial ownership and stock split announcements abnormal returns by examining 175 stock splits of 5 for 4 and greater that occurred between 1972 and 1986 with no other firm-specific announcements either on the day before or on the day of the split announcement Since stock splits have less information for firms with higher managerial ownership, these results provide evidence for the information effects, i.e signaling hypothesis Likewise, Szewczyk and Tsetsekos (1992) also provide support for the signaling hypothesis when they find an inverse relationship between the share price reaction to stock splits and the degree of institutional ownership The abnormal returns for firms with low institutional ownership are almost double that of high degree institutional ownership The information asymmetry is evidently greater for lower institutional ownership firms, and this discrepancy is due to the efficient

information acquisition activities of higher institutional ownership Hence, stock splits

convey more favorable private information to investors when the percentage of institutional ownership is lower.

Another version of the signaling hypothesis, an attention-getting model, is developed where managers with favorable inside information attract the attention of security analysts by announcing stock splits (Brennan and Hughes 1991) The lower post­split stock prices, according to this version, increase trading volume and trading

commissions for brokers giving them greater incentive to analyze and promote the stocks

o f these firms The support for this signaling hypothesis finds a negative relation to a firm’s share price when security analysts make earnings forecasts Therefore, the positive abnormal returns associated with stock split announcements in this model are due to market expectations of favorable information by managers

Similarly, Brennan and Copeland (1988) develop a signaling model in which the splits serve as a costly signal of the manager’s private information, because of the administrative costs of issuing the split and the increased transaction costs for investors via share price and odd lots Empirical evidence indicates that the number of shares outstanding after the split and the target share price provide useful signals of private information The signaling hypothesis is also supported when the results of comparing earnings and dividend growth rates for a test group of splitting firms and a control group

o f non-splitting firms show that investors may be concerned before the split that an earning reversal could follow the abnormally high earnings performance, which had occurred in the prior four years Managers o f these firms may issue the split to signal to investors the stability of earnings

4.1.1 b Trading Range Hypothesis

This hypothesis is also called the “optimal” or “preferred” range hypothesis Accordingly, managers utilize stock splits to reduce their firms’ share price to a preferred range The underlying assumption under which optimal range hypothesis works involves the individual stockholders preference to buy round lots The stockholder cannot afford to

do so when the stock price is high Moving the price into the preferred range, therefore, makes the market for trading in the stock wider or deeper by attracting more investors

An increase in investors should increase liquidity

Growing empirical evidence shows that managers utilize stock splits to restore share prices to optimal trading range Lakonishok and Lev (1987) suggest that managers issue stock splits to return their stock prices to a normal or acceptable level when they compare and find that closing monthly stock prices for the splitting and non-splitting group are similar four to five years before the split announcement, and in the remaining period leading up to the split announcement, the gap between the two groups widens monotonically until their mean closing prices reach $54.12 and $32.37, respectively, at the time of the split announcement Four months after the split announcement, the mean stock prices are almost similar and remain so for the remainder of the five-year post­announcement period The split factor is also used by managers to adjust their stock prices toward a market-wide price average and to an industry-wide price

In this direction, split factors are found to be an increasing function of pre-split share prices and decreasing function of market value of the firms (McNichols and Dravid 1990) Therefore, managers, when making the decision to split, have in mind some preferred trading range These ranges can be predicted, using pre-split prices, market

value o f a firm’s equity to approximate split factor, which in turn determines to some degree the preferred trading range.

Attention-getting can be included as part of optimal price range hypothesis (McNichols and Dravid 1990) Lower post-split price may increase the demand for a firm’s stock In turn, lower post-split price will generate higher commissions for stockbrokers and give them an incentive to sell the firm’s stock more aggressively Yet, institutional investors prefer high share prices to reduce transactions cost for a fixed dollar trade amount Therefore, the optimal price range results from conflicting demand preferences from these three parties (splitting firms, brokers, and institutions) In the context of this hypothesis, the mean number of institutions owning shares and the mean percentage of institutional ownership for the test group of splitting firms increased 20.7% and 13.3%, respectively, versus only 8.1% and 5.1%, respectively, for the control group (Powell and Baker 1993) The test group and control group are not statistically different six months before the split Yet, six months post split, the difference in the mean

percentage institutional ownership between test group and control group is found to be statistically significant The increase in these two institutional ownership variables is a function of firm size That is, when the firm size is large, the increase in institutional ownership is low and insignificant, whereas the increase in institutional ownership is high and significant when the firm size is small

After controlling for contaminating announcements, Lamoureux and Poon (1987) find the mean number of shareholders for firms announcing stock splits increased 34.65%

in the year of the split, while that of the non-splitting control group firms increased only

2.11% This implies that the stock splits play a role in changing ownership composition (mix), and small firms may issue stock splits to attract attention from financial analysts.

The liquidity hypothesis states that stock distributions (stock split and stock dividend) enhance liquidity by increasing the proportion of shares traded and decreasing bid-ask spreads Distribution of stock first brings the attention of investors to split shares and makes these shares more attractive to them in terms of prices Thereby, the number

of trades and the number of shareholders will increase and the increases in these two variables serve to increase a stock’s liquidity after the distribution Empirical support for liquidity hypothesis is mixed Copeland (1979), Conroy, Harris, and Benet (1990), and Lamoureux and Poon (1987) find that stock splits may reduce shareholder liquidity from different perspectives The first two studies report increases in the bid-ask spread after a split, whereas the third study reports a decrease in the mean market-adjusted, split- adjusted volume after a split Murray (1985) refutes the results of the first two studies by documenting that stock splits do not cause an increase in short-term trading activity Furthermore, he cannot conclude that stock splits cause a statistically significant decrease

in trading volume, and he finds no evidence of change in the percentage bid-ask spread for the splitting firms compared to a control sample of non-splitting firms Lakonishok and Lev (1987), however, conclude that stock splits cause an increase in trading volume

as measured by the monthly number of shares traded divided by the number of shares outstanding in the period around a split when they find statistical differences in the mean monthly trading volume between a sample of splitting firms and a control sample of non­splitting firms Month zero is signified with the greatest difference in monthly trading