What is a Reverse Stock Split?
Simply put, a reverse stock split occurs when a company decides to reduce the number of their shares that are publicly traded.
For example, let’s say you own 100 shares in Cute Dogs USA, and they are trading at $2 per share each. So, your total shares are worth $200 (100 x $2 each). If Cute Dogs decides to do a 1:2 reverse split, that means you will now own 50 shares, trading at $4 each. Your investment is still worth $200, but the stock’s price is double what it was. Earnings per share would also now be doubled.
That sounds good, right? Well, not so fast …
Why Would a Company Reverse-Split its Shares?
Investors have been trained by Wall Street to expect companies to split their stock, by adding to—not deducting from—their share count. And generally, those kinds of stock splits are good news.
But that is usually not the case with reverse splits. In fact—with a few rare exceptions—reverse splits are BAD news for investors. Here’s why:
The number-one reason for a reverse stock split is because the stock exchanges—like the NYSE or Nasdaq—set minimum price requirements for shares that trade on the exchanges. And when a company’s shares decline to near—or below—that level, the easiest way to stay in compliance with the exchange is to reduce the number of outstanding shares so that the price of the individual shares—like magic—automatically rises. And when that happens, the company’s shares can remain trading on the exchange.
Of course, while the shares may get an initial boost, don't expect it to last. If a company’s fortunes—and shares—have been waning, savvy investors will see the reverse split as a big red flag and continue selling, sending the shares back toward zero.
Most- although not all- reverse stock splits are seen in small penny stocks that have not been able to attain steady profitability and create value for their shareholders. I found that was the case in most of the biotechs’ recent reverse splits. Many are on the verge of bankruptcy, and they use a reverse split as a last-ditch effort to revive their failing fortunes.
But sometimes, companies will effect a reverse stock split so that their shares trade higher, with the intention of making them more attractive to mainstream investors and/or to ease the way to listing on a national exchange.
Here are some examples of recent reverse stock splits:
June 5: Amyris (AMRS), the industrial bioscience company, reverse split its stock 1-for-15.
May 5: Rexahn Pharmaceuticals (RNN), a clinical stage biopharmaceutical company did a 1-for-10 reverse split.
April 6: DryShips (DRYS), owner of ocean going cargo vessels, effected a 1-for-4 reverse stock split.
Many academic studies show the sad results of reverse stock splits, including a comprehensive study from the Stern School of Business at NYU and Emory University. Researchers looked at more than 40 years of data, from 1962 to 2001, and found that of the 1,600 reverse splits, shares underperformed their non-split peers by 15.6% the first year following the split, 36% in the second year and 54% in the third year.
I recently read an article from Bill Mathews, editor of The Cheap Investor, and one of our contributors to our Wall Street’s Best Investments newsletters, which gave a good example of a recent reverse split that didn’t turn out well. Here’s a brief excerpt:
“Last spring, I was talking with a friend about a stock that he had bought at $1 per share. Shortly after he bought, the price fell to $0.50. A few months later, he received notice that the company was planning to implement a 1 for 10 reverse stock split. He was wondering if that reverse stock split was a good or bad thing.
“According to the company’s press release, the reverse stock split of 1 for 10 would bring the stock price up to $5 per share, and that would prevent the stock from being delisted from NASDAQ.
“I ran into my friend a few weeks ago and asked about the stock. The stock, which was selling at $5.00 after the reverse, is now selling at $1.25 and he is down 88%.
“In this case, the stock moving from $0.50 to $5.00 overnight was just an accounting ploy. The company still had very shaky fundamentals. Savvy institutional investors won’t invest in the stock just because its price suddenly soared, and it will have a hard time raising capital if its balance sheet is poor. Shorters, who follow reverse stock splits and target those stocks, began to put pressure on the stock price, sending it tumbling. As selling pushed the price downward, other investors panicked and sold, causing the price to plummet even lower. As my friend discovered, a reverse stock split is normally not good news for shareholders.”
They’re Not all Bad
Sometimes companies decide to reverse split their shares just because they want to offer their shares at reasonable prices to attract new shareholders. There are examples of stocks that have prospered after doing so, including Citigroup (C). Citi probably had the most famous reverse split—a 1 for 10 reverse split in May 2011. Citi became a $40 stock, and is now trading at $50.05. The split was billed as “returning value to the shareholders.” The company had already survived the financial meltdown, and had begun paying a dividend, so investors thought it probably couldn’t get any worse. And they were right!
Other companies like AIG (AIG), E*Trade (ETFC), Motorola (MSI), and Priceline.com (PCLN), have endured—and prospered—after a reverse stock split.
You can see that these firms that not only survived but also prospered were fairly large and well-known businesses. And most studies have confirmed that firm size is very important in the determination of successful revers stock splits, along with operating and price performance PRIOR to the split, and, of course, market volatility.
I think you can conclude that, to be on the safe and conservative side of investing, if one of your holdings announces a reverse stock split, and it is a struggling, small company, you might do well to cut your losses. However, if it falls into the category of a well-run company, you can investigate a bit more to see if dumping your shares is the prudent thing to do.
Bill Mathews adds, “If a stock in your portfolio announces a reverse stock split, take a good look. If its fundamentals aren’t healthy, you might be better selling your shares. If you really like the stock, chances are good that you can buy back those shares at a much lower price several months down the road.”
Just remember, most companies who execute reverse splits falter, and many don’t survive. This is speculative investing, so make sure you do your homework.