What Is a Reverse Stock Split? Definition + Backtest Results
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What is a reverse stock split, and is a reverse stock split good or bad for investors? Let’s get into it by taking a closer look at the definition and the performance of all reverse stock splits of January 2020.
Reverse Stock Split Definition
The number of shares outstanding has a direct correlation to the price per share. If the number of shares outstanding get’s changed, then it directly impacts the price per share. During a reverse stock split process, a company cancels the current number of stocks outstanding and replaces them with new shares distributed to its shareholders. The overall value of the shares owned does not change it this process.
Let’s say you are holding 1,000 shares of company XYZ with a value of $0.5 per share equal to a position value of $500. XYZ decides to do a reverse split 1:20. In this case, you receive 1 new share per every 20 shares you owned before the stock split. After the stock split, both values are modified. Your number of shares in the portfolio is now 1,000 / 20 = 50 shares of the company. The stock exchange modifies the price per share by multiplying the old share price by 20. Therefore, the new shares are handed out for $0.50 * 20 = $10 per share. Before the stock split, you had a portfolio value of 1,000*$0.5=$500, and after the reverse split, you have 50*$10=$500. But why in the world does a company such things? Is it any good or bad to hold those shares?
Why Does a Company Perform a Reverse Stock Split?
Reverse stock splits happen almost exclusively on a company with shares below the $1. So-called penny stocks under $1 face a major problem. The company is in danger of getting delisted from major stock exchanges like Nasdaq if their stock price remains under $1 for 30 consecutive trading days. One day above $1 can save the company from delisting. Most companies want to avoid a delisting since a delisting usually leads to further financial issues. A reverse split immediately safes the company from delisting.
There are other more subjective reasons for a reverse stock split like intentions to polish the companies image and getting more attention from analysts by getting out of the typical penny stock scheme. But those things happen rarely.
How To Profit From a Reverse Stock Split
The bitter truth is that the process of doing a technical cleanup of the price per share does not solve a companies financial problem. It can be the first step, and other things like restructurings, realignments, and new products have to follow.
Is a Reverse Stock Split a Sell Signal?
Below you find two tables with all stock splits processed in January 2020. I analyzed the short-term price action and mid-term movements. The conclusion based on this testing group is that a reverse stock split is a sell signal for existing positions more often than not.
First Day After the Reverse Stock Split
My analysis has shown that the volatility on those days is exceptionally high, but the opening price’s tendency to the closing price on that day is sideways. The mean value of the change between open and close on that day is -1%. Three out of then were positive, one sideways, six negative.
Results After the First Half Year as of June 30, 2020
The picture got even worse after the first few months. Only 3 out of 10 stocks have shown substantial gains. Seven lost in value, and two of them even 80% (INPX) and 82% (EYES). RENN and USEG performed well and helped to get the mean value to “only” -11%.
Results as of Q3 2020
The picture slightly improved in Q3. Penny stocks are pretty popular right now, and some companies’ restructuring processes might already have a positive impact.
A reverse stock split does not guarantee excessive gains for new investors or existing shareholders. The announcement of a reverse stock split might boost the price per share in the short term and the first trading day after the stock split often offers good chances for day traders to make profits with the help of high volatility on that day. The data does not suggest that buy and hold investors profit in the long run. All kinds of investors are well-advised to focus on a company’s health, key financial data and announced measures that follow the reverse stock split.
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