Can you profit from a reverse stock split? It is possible, but there are real risks involved in trying. Understanding what a reverse split is and why it happens can help you make the right decision.
A reverse split occurs when a company wants to reduce the number of its outstanding shares by merging a certain number of existing shares into one.
A 1:5 reverse split would take 5 shares and turn them into 1. There are no rules about the scale of a stock split, and it can be as large as a 1:100 conversion ratio.
The total market capitalization or value of the company does not change. It will simply be distributed among a smaller number of shares.
Let’s say you own 100 shares of a company that is trading at $1 per share. If the company had a 1:5 reverse stock split you would own 20 shares of stock worth $5 a share after the split.
A shareholder who has an uneven number of shares, for example, holding 52 shares in a 1:5 reverse stock split, will be given 10 newly merged shares and cash for the remaining 2 shares.
All the shares of the company are subjected to this change. Usually, your broker will notify you and take care of any required changes to your records.
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Reasons for a Reverse Stock Split
Companies typically use a reverse stock split to increase the per-share price of the company. There are several reasons why a company would do this.
- Avoid a “penny stock” classification. Stocks in the “penny stock” group are often viewed as risky and of low quality. Many institutions will not buy them at all, and some brokers may restrict penny stock trades.
- Increase interest in the stock. More expensive stocks tend to catch more attention.
- Avoid delisting. Some stock exchanges require a minimum share price for a listed stock. If a company’s stock price has declined below this level, a reverse split can be done to avoid a de-listing.
Most of these situations occur because a company’s stock has experienced a significant decline in value.
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Are Reverse Stock Splits Bad?
By itself, a reverse stock split is not a bad or a good thing, but it often indicates trouble in a company.
For example, if it happens after a large and persistent share price decline, this could indicate that the company is not doing well, and is losing money and/or the trust of investors.
On the other hand, if this is a way to promote the company and speed up the moment when the stock will trade at a higher level, it can be a good thing and bring the stock onto the radar of institutional investors. This might be the case for a growing company, or a startup that has now developed a viable product and business.
A reverse split can be done because a company currently trading on the OTC (Over-The-Counter) plans to move up to a major exchange with a minimum stock price. In this case, a reverse split could be a positive sign.
How to Profit From a Reverse Stock Split
There is no guaranteed way to profit from a reverse split (or any other stock adjustments), but there are some exploitable situations to watch for.
Short Selling
One way to profit from reverse stock splits is to use them as an indicator of a company in trouble. If the financial metrics match, this could be a good stock to short. as the reverse stock split might trigger more selling and price weakness.
Repeated reverse stock splits are a particular red flag, as they are likely to indicate a continued and drastic loss of value.
Be careful, especially if you don’t have experience with short selling! Short trading strategies can be dangerous and expose traders to almost unlimited losses.
Reorganization
Reorganization is another way one can profit from a reverse stock split. Some companies, especially large conglomerates, can reorganize their business structure, sell assets, merge departments, and take other steps designed to increase the long-term profitability of the company.
These moments are sometimes also used to do reverse split, in order to put the price per share more in line with competitors and the industry’s standards. A recent example was GE.
The purpose of the reverse stock split was to reduce the number of our outstanding shares of common stock to levels that are better aligned with companies of GE’s size and scope and a clearer reflection of the GE of the future, not the past.
It also marks another step in GE’s transformation to be a more focused, simpler, stronger high-tech industrial company.
In this case, it might indicate a renewed focus, a better strategy, and improved use of capital moving forward. This might indicate a stock with a higher chance to grow in price.
Sneaky Privatization
The last way to profit from a reverse stock split, which occurs rarely but is technically possible, is for a reverse stock split to be used to force the majority of small investors out of the company.
Shareholders who don’t own enough shares to receive at least one post-split share will receive cash instead.
For example, a 1:1000 reverse stock split could be used to force out all small shareholders. When a publicly listed company falls below a certain threshold for its total number of shareholders, it can be forcibly taken private.
This is rare, but it has been known to happen for startups and other companies with some very large shareholders (like early investors or founders) interested in pushing out minority shareholders and taking the company private. This might be quite dubious morally, but will be legal most of the time.
In these cases, this indicates extreme confidence by the majority shareholders in the future prospects of the company. You could decide to ride along and keep the shares.
This can be risky, as clearly the management does not have minority shareholders in mind, and might do other things later on that would reduce the returns on this investment.
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Conclusion
Reverse stock splits can be confusing for investors, especially non-professionals. But in most cases, they are not very significant events. Even when they come after a severe stock price decline, it is that decline that matters, with the stock split a mere symptom of the underlying issue.
It could be worth looking at the company website for its official announcement and the explanation for it. Most management teams will clearly specify why they are doing a reverse split. Understanding the reasons behind the move may help you determine the most appropriate reaction.
If you’re looking to profit from a reverse stock split, be careful. You’ll need to examine the situation carefully and reach an accurate conclusion on why the reverse split is happening and what the outcome will be. It’s a potentially profitable strategy, but there are also substantial risks.
