The Reverse Stock Split’s Impact on Shareholders

Companies that engage in reverse stock splits have a terrible track record of underperformance against the stock market as a whole. Theoretically, changes in the arrangements of a corporations’ share count should have no effect on the underlying business, yet research shows that these types of splits are associated with underperformance.

A reverse split occurs when a company recalls your shares and issues you a fewer number of shares that trade at a higher price. In other words, the whole point of a reverse share split is that the company is saying that it’s better for you to have one hundred dollar bill rather than five twenty-dollar bills.

The Basic Overview

When the bylaws are drafted for a corporation, the Board of Directors are almost always granted unfettered authority to determine the capitalization structure. If a business raises $1 million, the corporation can decide to break it into 1,000,000 shares that trade for a $1 or 10 shares that trade for $1 million each, or any other share arrangement that the management team freely decides.

Historically, in order to ensure adequate liquidity for selling shares, the target initial price has been $10 per share. In the event that $1 million is initially raised to start a company, the typical practice would be to issue 100,000 shares that trade at a starting price of $10 per share.

Sometimes, the business deteriorates after this initial capitalization and the price of the stock plummets.

Under these circumstances, a Board of Directors frequently considers a reverse stock split, which bolsters the price of a stock by reducing the share count outstanding.

In the above scenario, if those 100,000 shares outstanding that initially traded at $10 per share fell to $2 per share, and the company wanted to restore the price of the stock, it might issue a 1:5 reverse stock split in which the share count of the business would be reduced to 20,000 shares outstanding that trade at a price of $20 per share.

This action does nothing to limit the hypothetical 80% loss experienced by investors. If you owned 100 shares at the initial price of $10 per share, for a total investment of $1,000, and the price subsequently fell to $2 per share, at which time the corporation announced a 1:5 reverse split, you would find yourself sitting on 20 shares worth $10 each for a value of $200.

What motivates a company to issue a reverse stock split?

There is usually a logistical and psychological reason behind every reverse split.

For a stock to be listed on a major exchange, there is generally a requirement that it maintains a price of $1 per share. Once a stock falls below that price, the exchange itself will notify the company that its average price must come above the $1 mark within the next 90 days or else risk delisting. If the business performance of the company does not improve during this cure period, the stock is usually removed from the index.

This poses major liquidity problems. While the investors still own their shares, they won’t be able to easily log onto a website like Schwab or Ameritrade and sell their stock. Instead, their shares will trade on the over-the-counter pink sheets, which leads to inefficient pricing and difficulty unloading positions (remember, anytime you sell a stock, there must be a buyer, and there are far fewer buyers on the over-the-counter exchanges).

Often, reverse stock splits constitute a last-ditch effort to keep a stock on a major exchange like Euronext, the London Stock Exchange, the New York Stock Exchange, or the NASDAQ. If a stock falls to $0.90 and a company executes a 20-for-1 reverse split, the stock price will rise to $18 per share and remove the risk of delisting (though every 20 shares that the shareholders own will be reduced to a single share as a result of this financial engineering device).

Another basis for a potential share consolidation is the desire to keep institutional investors eligible to purchase the stock. Many large endowment funds, such as Dartmouth and Vanderbilt, have a requirement that any stock purchases for the endowment must trade at a price of $1 per share or higher. Some insurance companies as well as retirement and pension plans have similar governing rules. A reverse split keeps the stock eligible for purchase by the professional class of investors.

Outside of these logistical concerns, the other major reason for a stock split is largely psychological. People don’t want to own stocks that trade for $0.70 per share. It feels scammy and rife with speculation. No one ever talks about blue-chip penny stocks. A reverse split is an effort to add a patina of class to a company whose recent stock performance does not deserve it.

Notable Reverse Splits In Recent History

The only truly successful investment following a reverse stock split that has occurred in my lifetime is Priceline, now known as Booking Holdings, Inc., which orchestrated a reverse 1:6 stock split in 2003 to stimulate the price above $20, and it has subsequently gone up to a price over $2,000 due to the immense success of priceline.com.

The rest are far less cheery. AIG, Citigroup, Tyco International, DryShips, Xerox, Frontier Communications, Motorola Solutions, and Time Warner have all executed reverse splits that have been associated with the destruction of shareholder wealth. Collectively, they have only compounded at a collective rate of 4.7% since the date of their splits.

The Investment Performance After The Split

After a reverse split, the stock of the company tends to underperform the stock market index dramatically. The most robust study of a stock’s performance after a reverse stock split was conducted by Ibbotson & Asssociates in 2017.

The constraints included the following:

  1. The company had to be one of the 5,000 largest corporations in the United States at the time of the share rollback occurrence.
  2. The years analyzed covered 1926 through 2017.
  3. The subsequent performance after the split was measured for five years in comparison to the relevant index—first, the Dow Jones, and later, the S&P 500.

The differential was staggering. For companies that executed a reverse stock split, they went on to underperform the stock market by 4.3% annually during the subsequent five-year period.

Over a fifty-year time frame, the difference would be a factor of 17—i.e. for every $1 million in wealth created by investing in a plain vanilla index fund, only $58,800 in wealth would be created by an index that consisted of nothing but companies that executed reverse splits over the past century.

Part of this dramatic under-performance is to be expected in that companies whose share prices fall so dramatically that a reverse split is even contemplated must be facing one heck of a problem.

Also, it may be an indictment on the management team. By definition, any share modification is a cosmetic change that doesn’t intrinsically change anything about the business but is instead aimed at changing the perception of a given business. If the management is worried about changing investor perceptions about problems rather than fixing the problems themselves, well, it shouldn’t comes as a surprise that problems continue to manifest themselves.

Most intriguing, only 32 reverse splits in the history of the United States have ever gone on to outperform the stock market. That should give one pause before investing in the stock of a company that subjects itself to a split aimed at reducing the share count and raising the stock price.

What happens if you own partial shares during the split? 

Let us assume that a corporation announces a reverse 1:10 stock split—i.e. if you own ten shares trading at $1, you will have 1 share trading $10 after the reverse split is complete. The division is pretty simple if you own multiples of 10 shares in this illustration—the reverse split turns 10,000 shares into 1,000; 1,000 shares into 100; and 100 shares into 10 shares.

Ever since the rise of the discount brokerage house in the 1990s, investors stopped limiting themselves to round lots of 100 shares each. As such, many people find themselves owning 32, 188, or 1,032 shares of a stock.

So what happens if you own 107 shares of a stock trading at $1 per share that undergoes a 1:10 stock split?

As a matter of course, the 100 shares will become 10 shares worth $10 each.

The default rule is that the 7 shares will become converted into cash and you will be issued a brokerage house credit or a physical check in the amount of $7 because the SEC only requires stock splits to convert to whole share amounts. Worst of all, if held in a taxable brokerage account, those 7 shares will be subject to taxation as though you had voluntarily sold the shares.

However, I should stress that this is the default term. Brokerage houses, and the transfer agent that executes the reverse stock split, may choose to convert the original shares into partial shares in their discretion.

If the company itself chooses to direct its transfer agent to convert the original shares into partial shares (i.e. turning 107 shares into 10.7 shares after the reverse stock split), the announcement itself will give you this information since it is an alternative to the default rule.

In the event that the transfer agent of the company only agrees to a cash payout for the partial shares, you may still be able to reinvest the payout by directing the brokerage house to do so.

I checked with Charles Schwab and TD Ameritrade, and both brokerage houses have the same policy—if you contact them within thirty days of the split, you can have the cash distribution reinvested if the volume of shares traded daily exceeds 10,000 for liquidity purposes. The downside is that approach does create a taxable event.

There are instances in which the rules for fractional shares is more than a pedantic concern. If you own the 107 shares in stock certificate form, and the company opts for the default rule of a cash distribution for fractional shares, those 7 shares remain fixed at the cash-out price.

If the company recovers and increases exponentially over the coming decades, those 7 shares will not participate in the growth of the stock price after the split event—you will only get the much lower cash-out amount for the shares. Alternatively, if the company flounders and files for bankruptcy, your fractional shares will have a superior priority claim to the liquidation value of the fractional shares than the senior bondholders and other shareholders.

Most famously and dramatically, the shareholders in Blue Chip Stamps that failed to tender their shares in exchange for Berkshire Hathaway stock in 1983 would only be entitled to $700 per share in cash for each share rather than the $300,000 per share price of Berkshire Hathaway stock today (though this was in connection with the fractional shares of an acquisition rather than reverse split).

In short, you should look to the announcement itself to see what happens to the partial shares. If the company does not affirmatively announce that fractional shares can be created, you should assume that you will receive a cash payout for your fractional ownership position. Otherwise, you can contact your brokerage account and seek reinvestment, which will result in a taxable event.

Conclusion

A reverse stock split is almost always a good indicator that you should stay away from the business. Priceline, now known as Booking, is the only company that executed a reverse stock split that went on to create substantial wealth in the previous generation. The data indicates that the reverse stock splitters dramatically underperform the stock market as a whole, perhaps due to the litany of problems that cause a reverse split in the first place as well as the fact that it indicates the management team is more focused on changing perception than the reality of the business issues.