In a reverse stock split, a company consolidates shares at a fixed ratio. In one example, every 10 shares is consolidated into a single share going forward. Because the total value of the company hasn’t changed, this new share is worth 10 times the price of an old share. The value of your investment is theoretically the same before and after the reverse split.
What happens to share price after the reverse split? A 2008 paper by Seoyoung Kim, April Klein, and James Rosenfeld studied the return performance of 1,600 firms with reverse stock splits between 1962 and 2001. They found that firms undergoing reverse splits performed significantly worse over the following three years than peer firms of similar size in similar industries.
Share price is down 45% just 3 years after a reverse split compared to similar firms. One could try to short these firms, i.e., borrow shares and sell them immediately after the reverse split, then buy them back on the open market after a few years at the new lower prices. The authors thought of that, but noted that shorting stocks with share price below $5 is quite difficult and often impossible for retail investors. Furthermore, the decrease in share price was almost entirely due to stocks with under $5 share price — those companies were down 67% after 3 years compared to just 11% for those with post-split share price greater than $5. We know which stocks will go down, we just don’t have a way to profit.
Another study by Jae-Kwang Hwang, Young Dimkpah, and Alex I. Ogwu from 2012 analyzed reverse stock splits from 1981 to 2010. They found that share price dropped significantly in the day and month after the reverse split, but outperformed peers from months 2 to 36. The authors theorize that this is due to more investments from large funds, as institutional holdings increased by 10 percentage points following a reverse split. Although they don’t acknowledge it, it seems highly likely that the rise of index funds since 2000 may play a role, as index funds are obligated to purchase stocks that meet certain requirements, one of which is minimum share price. Index fund interest could increase demand and further raise share price.
Kee H. Chung and Sean Yang in 2015 studied institutional investor holdings of stocks that reverse split. They found that stocks with a pre-split price of less than $5 and a post-split price of more than $5 showed larger increases in institutional holdings than other reverse splits. This seems to support Hwang et al.’s theory that using a reverse split to cross the $5 threshold seems to motivate institutional investment.
So what does this mean?
In short, the theory appears to be that the reverse split initially allows shareholders to sell easily as the price increase lowers transaction costs. That is, a bid-ask spread of $0.01 represents 2% of a $0.50 stock but only 0.2% of a $5 stock. Those pennies add up when liquidating a million dollar position.
After the initial sell off, institutions and index funds can then purchase shares, driving up prices. I suspect the rise of index fund investing in the last 20 years is a significant factor explaining the difference between Kim et al.’s and Hwang et al.’s findings. I plan to research this further.
Is there another, less risky way to profit from reverse splits?
There is one way to consistently profit off reverse stock splits. Say a company performs a reverse stock split at a ratio of 1 to 10. If you had bought 1 share before the split for $0.50, after the split you’d have 1/10 of a share, a fraction which historically could not be traded. To get around fractional shares, companies will sometimes pay the cash value of the fractional share, in this case $0.50. Other times, though, they will round you up to one full share. When they round up, the share you had bought for $0.50 is now worth around $5. You profit $4.50 at minimal at risk.
It’s nice, clean profit, but $4.50 is too small to get excited about. You can’t buy more shares in the same account, as that just means you’ll get rounded up less. You can, however, purchase a single share in multiple accounts at multiple brokers and let them all round up. There are at least 16 brokers that round up fractional shares from reverse splits.
If you’re interested in trading reverse splits that round up, subscribe to my newsletter and Twitter to get notified of upcoming splits the day they happen. Make sure your broker is one that rounds up fractional shares (some don’t round up as policy, while others charge fees). A running list of participating brokers can be found here along with sign up links to get you free stocks. If you’re interested in recent successful trades, they are posted here. More information about trading reverse splits can be found on the homepage here.