The reverse stock split trend continues. Just since the beginning of 2018, my quick count (by no means exhaustive!) came up with 90 reverse stock splits, and 118 for 2017. I found that most of the splits were in small biotech stocks, followed by technology, then energy.
The splits in energy aren’t unexpected, as after vast expansion in the industry, low oil prices sent many fortunes reeling. And the biotech and technology companies were mostly cheap stocks with shaky fundamentals, or companies like Frontier Communications (FTR) that have run into some misery. As well, the biotechs are mostly a speculative bunch with the need to burn cash at a rapid rate, so I can’t say I was too surprised to see the abundance of their reverse stock splits.
Most of the time, these splits are not good for investors. And with such an escalation in reverse stock splits, I thought it might be time to review the good and the bad aspects of reverse stock splits in case you own shares in a company that just executed or are contemplating executing a reverse split.
What is a Reverse Stock Split?
Simply put, a reverse stock split occurs when a company decides to reduce the number of its 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 are also now 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’s 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 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 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 couple 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:
“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.”
But when Xerox (XRX) split its stock 4:1 in June 2017 (chart above), the scenario looked much different. Our contributor, Ian Wyatt, editor of High Yield Wealth wrote, “So why did Xerox bother with a reverse stock split if investor wealth remains unchanged? Visibility is the answer. Many institutional investors—mutual funds in particular—ignore stocks priced in single digits. Many investment firms ignore these stocks as well. Xerox is trying to raise its profile with its reverse-stock split.
“We’re agnostic on the reverse stock split. It could raise Xerox’s standing among institutional investors and research analysts. It could also lower Xerox’s standing among other investors. Some investors are repelled by reverse stock split. They view a reverse stock split as an insincere strategy for raising the share price. Financial performance ultimately determines value and price in the long run.”
The shares of Xerox did go up for a while following the split, but fell back, and since the company’s announcement of a merger with Fujifilm, shareholders have filed various lawsuits, dragging the share price further down.
Reverse Stock Splits Aren’t 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 $62. 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 prospered were fairly large and well-known businesses. And most studies have confirmed that firm size is very important in the determination of successful reverse 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 that execute reverse stock splits falter, and many don’t survive. This is speculative investing, so make sure you do your homework.
One other way to profit is to get a list of stocks that the best Wall Street’s gurus are recommending when taking a subscription to Wall Street’s Best Investments, which I edit.
Nancy Zambell, Editor of Wall Street’s Best Investments, has spent 30 years helping investors navigate the minefields of the financial industry. Nancy scours more than 200 advisories and research reports to select the top recommendations, which she collects for you in this easy-to-read digest.Learn More
*This post has been updated from an original version, published in 2017.