Reverse Stock Split Strategy
Stockholders may at times find reward when a held stock makes a split. This is usually a clear sign of good health for the company. A reverse stock split, however, usually bears a negative message in its cause and intended effect. But there are occasions in which a reverse stock split may signal recovery or better. Your best strategy during a reverse split depends on several factors that can help you decide whether to hold or short.
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Reverse Split Explanation
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When a company's stock price rises to a high value, the company may split the existing stocks held by shareholders. By splitting the stock in a ratio, usually 2 to 1, the current shares become multiplied in that ratio, so that a holder of 1,000 shares would then own 2,000 shares each worth about half as much. A reverse stock split can be something like a 1 to 2 ratio, meaning that for every two stocks a shareholder owns, one share is now owned that's worth twice as much. The reverse split reduces the total number of a stockholder's owned shares by a factor equal to the split ratio, effectively increasing the value of each stock while reducing the total number of stocks in issuance.
Intended Effects
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The most common motivation for a reverse stock split is to bring share values to a level that will prevent the stock from being delisted by an exchange. Many times that value is $1. By using a reverse split, a company can increase the stock value to an amount above the cutoff mark and hopefully garner more confidence from traders as well. But according to some estimates, 75 percent of companies that are forced to resort to this tactic end up losing more value after the reverse split, according to MSN Money.
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Positive Signs for Recovery
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One good sign for a company's recovery after a reverse split is when that company's prospects have improved around the time of the split. For example, an improvement in efficiency or new capitalization. Another positive sign is for the company to have continually strong cash flows along with a trend of heavier stock purchasing from insiders. Avoid shorting in these instances.
Prospective Future
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On average, a reverse split results in a 37 percent decrease in stock value over the subsequent three years, according to MSN Money. With these odds, shorting a company performing this maneuver is a fairly safe bet, especially when a company exhibits weak cash flow or other telltale signs of a sinking ship. However, keep in mind that some reverse splits are sometimes done for cosmetic purposes, or are executed with sufficient cash flow in place to succeed, so examining the company's past and recent history are imperative before potentially shorting a rallying stock.
Noteworthy Cases
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In 2002, j2 Global Communications stunned speculators when it gained over 800 percent in the months after a reverse stock split was used as a bailout. Also in 2002, Palm Inc. issued a reverse split of 1:20. The company survived, and in 2010 expected to be acquired by Hewlett-Packard. These cases show examples of how a reverse split is used with success, rather than being a telltale of further trouble.
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References
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