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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’s usually not the case with reverse stock splits. In fact—with a few rare exceptions—reverse stock 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 their 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 share price back down.
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 stock 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 affect 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 reverse stock splits in the last few years:
Xerox (XRX) June 15, 2017: 1 for 4
Frontier Communications (FTR) July 10, 2017: 1 for 15
DryShips (DRYS) July 21, 2017: 1 for 7
Staffing 360 Solutions (STAF) January 4, 2018: 1 for 5
Harte-Hanks (HHS) February 1, 2018: 1 for 10
Researchers at the Stern School of Business at NYU and Emory University looked at more than 40 years of data, from 1962 to 2001, and found that of the 1,600 reverse stock splits, shares underperformed their non-split peers by 15.6% in 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, which gave a good example of a recent reverse split that didn’t turn out well. Here’s a brief excerpt:
“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.”
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