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?”