Is a Reverse Stock Split Good or Bad?
There is a misconception floating around that a reverse stock split is always bad news. This is incorrect. While it’s true that some of the time a reverse stock split is bad, it’s not 100% of the time. In this article we’ll explore reverse splits and what indicators to look for to tell whether it’s good or bad.
What exactly is a reverse stock split?
It’s the opposite of a stock split. For clarification on a stock split, read this: What is a stock split and how does it work?
To summarize, a stock split multiplies all outstanding shares by a set amount. Usually by two or three. So, a reverse stock split is the opposite. It will divide all shares by a certain number. This number is usually much bigger than two or three. It’s not uncommon to see 1 for 5 or 1 for 10.
If you own 9,369 shares and there is a reverse stock split of 1 for 5, you’ll now own 1,873 shares, and the leftover fractional share will be converted to cash and deposited in your account. The value of the company hasn’t changed at this point. If your balance was $45,000 then it’s still $45,000. All that has changed is the stock price and the number of outstanding shares.
If you’re used to reading fake comments or paid basher posts, you’ll notice a lot of them will harp on the idea of a potential upcoming reverse split and how terrible that is for the company.
Don’t get me wrong, some of the time a reverse split is a very bad sign. But sometimes, it’s a great sign. It can signal faith in the company and the products by management.
How do we identify whether a reverse split is good or bad?
We’ll start with the bad.
Here are six reasons to look negatively at an upcoming reverse split.
1. Stock price has dropped under listing requirements.
To not be de-listed from certain stock exchanges, like the NASDAQ, stocks must keep their price above a certain amount. Usually, a round number like $1.
In the long run, stock price reflects a company’s performance. If they’re doing poorly, the stock price will drop. If it drops too low, they get a de-listing notice.
“Get your stock price above $1 or we’ll kick you out of the club.”
Getting kicked off a big exchange is not only devastating to your credibility, but it also makes it near impossible for institutions and small investors to invest in your company. Most people don’t buy OTC (pink sheets) stocks. These are mostly unregulated, extremely risky, and some are downright fraudulent.
Companies faced with a de-listing notice will do a reverse split to not get kicked off the exchange. This is just one indicator that things are going poorly. A de-listing notice does not mean bankruptcy or guaranteed dilution. It’s just not a great sign.
Examine what your sector is doing. If everyone else’s stock has been dropping steadily for months because the entire sector is getting trashed, then a de-listing notice might just be unfortunate timing. As in, your stock was floating around $1.40 which was fine, but then dipped under $1 for a few months due to external market forces, which have nothing to do with the operation or potential of the company.
In the event of a sector crash, a delisting notice and corresponding reverse split is irrelevant.
In the event the company is doing poorly, a delisting notice and corresponding reverse split is bad news.
2. Expenses drastically outweigh revenue.
What is your company’s cash burn rate? How much cash do they have on hand? Is it enough to last a year? If not, then you could be looking at an equity raise and shareholder dilution. How much cash a company has is public knowledge. You can see it, and so can Wall Street. When a company is running low on cash, they sometimes get heavily shorted by investment banks. This allows other banks or hedge funds to buy equity at even cheaper rates.
Investment banks are worse than the mobsters from the 80s going door-to-door in strip malls demanding payment for protection. Instead of asking for money, investment banks burn down your business then buy the ashes.
Running low on cash is very bad. Companies are not people. They can’t run the savings down to nothing and start putting their expenses on credit cards. Salaries and rent must be paid and those must be paid in cash.
If a company is struggling to pay their bills, then a reverse split is a bad sign.
3. Company has done reverse splits in the past.
Companies that do reverse splits get addicted to them. They turn into a crutch. CEOs get this idea in their heads that they can take extraordinary risks and gambles because if it doesn’t work out, they can always do a reverse split to prop the share price up again.
If your company did a reverse split within the past two years this is a bad sign. If they’ve done multiple reverse splits, it’s a very bad sign.
4. Company has done ATM equity raises in the past.
Let’s say your company did a reverse split in the past few years. What happened next? Did they issue more shares to raise funds? If so, what did they do with those funds? How were they spent? How much revenue was generated?
If after the last reverse split, they diluted everyone by 30% to raise money to buy advertising, and the advertising didn’t result in huge sales, this is a catastrophic sign. It means not only is the product probably junk, but it also means the CEO is probably junk.
They’re suffering from a bad case of moral hazard. They’re not treating your investment like its their own.
5. CEO is overpaid relative to peers.
How much of a stake does the CEO have in the company? What’s their salary like? Overpaid CEOs don’t care diluting the company because most of their income comes from salary, bonuses, and option grants. Narcissists and psychopaths always act in their own best interest, even if they have a fiduciary responsibility to act in your best interest.
The more overpaid the CEO is relative to their qualifications, performance, and peers, the more dangerous a reverse split is. Allowing bad CEOs to do reverse splits and dilute shareholders is akin to giving rocket launchers to tribal warriors living in the stone age.
It ends poorly for everyone, especially the little people.
6. Majority shareholders own preferred shares.
Is the CEO the majority shareholder? Do they own preferred shares? Have they diluted only the common stock in the past? This is the worst sign. Get out now. This CEO has zero interest in the common stock. They plan to dilute as much as they can without getting arrested.
After they’ve raised enough cash, they’ll take the company private. This is unfortunately a legal scam. Like the DryShips fiasco.
Okay, now that we know the bad signs to look for, we’ll examine the other side.
Five reasons why a reverse split can be a great thing.
1. Stock doesn’t have many institutional investors.
Sometimes we make up investing rules in our head. “If the stock drops 10% I’ll sell it.” Or, “Never buy penny stocks.”
Sometimes we stick with our rules, sometimes we don’t.
Institutions, like pension funds and mutual funds, also have rules. One of the most common rules is they don’t buy lottery ticket stocks. They don’t buy small companies with volatile stock prices and low volume. This is because these types of companies are inherently risky and it’s tough to unload a position without getting hosed on the price.
They set rules like, “Never buy any stock that trades under $5.”
Unlike you and me, institutions almost always stick to their rules. The managers have to. If they don’t, they get fired.
What happens sometimes is a small company is approached by a large fund or an investment bank and there’s a conversation along the lines of, “Hey we love your company, but our corporate guidelines forbid us from investing in it because your share price is too cheap. We want to get in on the ground floor, so would you consider doing a reverse split?”
2. Stock doesn’t trade options.
While you might not buy or sell stock options, institutions do it all the time. Banks like Morgan Stanley and Goldman Sachs will sometimes do it for short-term trading profits, but a lot of options are bought and sold as hedges.
Say you own 1 million shares of a company trading at $50. That’s a large position. You’re optimistic about the future of the company, but there are some short-term catalysts that freak you out a bit. You’re unwilling to sell your shares because selling such a large block is difficult and you don’t want to sell for less than market prices. What’d you do here is hedge your position with put options.
It's like insurance on your stocks. If the price drops, the insurance pays out. If the stock stays the same or goes up, you lose the money you paid for insurance. But, the stock has gone up so you don’t really care.
If a stock doesn’t have options, institutions can’t do this. Options are an important part of a healthy market.
Not every stock can have options. Here are the requirements as listed on Investopedia.
Number five is price. This ranges from $3 to $7.50. The stock price must be above this amount for at least 50% of trading days in a three-month window.
So, if institutions are planning to buy large blocks in a company, and they want options enabled, they might ask a company to do a reverse split.
“We want to buy 5% of the company, but you need options first. Do a reverse split and we’ll chat again in a few months.”
If your stock is trading near $1, then a 1 for 10 split would more than solve this.
3. Company has numerous milestones within the next year.
If your company has a lot of catalysts coming up, then a reverse split can the share price ready for the general public. It’s completely irrational, but people pay more attention to the stock price than they do the market cap. Probably due to media headlines touting so-and-so stock just hit a new record high.
Stocks trading at or under $5 have a bad reputation for being risky or shifty. Especially if they haven’t moved in years. Index fund investing has conditioned most people to expect a chart that looks like this if a company is good.
$SPY five year chart.
Profitable companies have gradually building slopes. They go up over time because good companies go up over time. This is what they’re hoping to see when they look at the chart you’re showing them.
“Check out this stock, it’s the next great thing!”
Your friend opens the chart and sees this:
$MTNB five year chart.
Pretty horrifying. It looks like they’ve accomplished nothing in the last five years. But this is the chart you’d expect to see for almost any start-up. Especially biotech.
Spikes come from news releases and excitement. Over time these spikes flatten as people realize it will take years to translate this news into revenue.
Here is the Tesla chart from July 1st 2010, up until today. See how it was basically flat for almost a decade? That’s the boring part of investing. That’s where Wall Street can play games. It’s easy to shake someone out of a position if revenue is years away.
$TSLA max chart.
4. Market capitalization is undervalued relative to peers and potential.
What is your stock’s market cap? Where does it sit relative to peers? If you’re trading at 200 million, but your competition is trading at a billion, then you’re probably undervalued. In this case, a reverse split is not a bad thing. Management is just trying to prop up the share price.
5. Stock can’t trend on social media finance boards because it’s too cheap.
Sometimes great news is released and a stock pops 50%. All of the long-term shareholders are posting comments on the message board. Message volume is through the roof. But the stock can’t be seen in the “trending” sections.
This is because it’s too cheap. Did you know on StockTwits that a company can’t trend unless the stock price is $5? This is to prevent manipulation of the trending section by penny stock pump-and-dumps.
If a reverse split would send your stock price higher than $5, that’s great. That means when the good news does drop, the stock will be seen by more people. This is free advertising to attract new investors.
Put on your detective’s hat
Whenever there are rumors of a reverse split, bears pour out of the woodwork and scream dilution. But this isn’t always the case. Each company must be thoroughly examined. You must discover the underlying reason behind the split.
If it’s so they can raise money and dilute shareholders, then you should probably sell
If it’s to make it easier, or more exciting to invest in the company, then you should probably hold.
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