July 13, 2011 | In: Opinion
Are Reverse Splits Good for Stocks?
In this current market, we are seeing more and more reverse splits taking place. The latest prominent reverse split was Citigroup’s, which outcome wasn’t (to say the least) impressive. When there’s a reverse split, new investors wonder, is that good for the stock? Is it a good sign?
I’m not going this time to wait until the end of the article to answer this question, so I will answer now: “Generally, reverse splits are a bad sign”.
Now that you know that reverse splits aren’t the best thing that can happen to a stock, you probably need to know why. Well, to explain why, let me discuss first why companies resort to reverse splits.
Reasons for reverse splits
Executives in a company do not wake up one day and decide “hey, we are going to do a reverse split on the stock, we will have less shares and the stock price will be higher”. Usually, there is a valid reason behind a reverse split:
- The stock has dropped below the $1 level: As per the NYSE and the NASDAQ rules, a stock cannot drop below the $1 level for more than a month. Failing to comply with this rule can cause the stock to be delisted. Companies do a reverse split in order to avoid getting kicked out of the market.
- The stock is being abused because it’s very cheap: If a stock is very cheap, and the volume on the stock is low, then the stock can be abused by even the smallest investors. If the company does a reverse split on its stock, then the stock will no longer be abused (at least by small investors).
- Fear from being labeled as a penny stock: Prominent companies, such as Citigroup, refuse to have their stocks labeled as a penny stock, which, in the opinion of many investors, including myself, is any stock trading below $5.
- Pessimism about the future of the company: If an already cheap stock is in a downward spiral for an extended period (with little hope of going up), then the company may decide to do a reverse split in order to maintain the prestige of the stock (otherwise, the stock may become a penny stock).
As you can see from the above, a reverse split is never the sign of a healthy stock, in fact, it is the sign of a very bad stock, that is stuck in some bearish hell, a stock whose company believes that its chances of going up are very dim.
Still don’t agree with me that a reverse split is bad news? Let’s check a couple of charts:
So, do you still think that reverse splits are good?
PS: A good question to ponder is the following “Which one of the above reasons did Citigroup and AIB take into consideration for doing the reverse split?”