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Reverse Splits: Fewer Pieces of a Smaller Pie

With more stocks sinking below $5, companies may increasingly adopt the less-is-more approach to bolster their shriveled shares

Wall Street's $5-and-under club has a lot of new members these days. Almost 10%, or 47 companies in the Standard & Poor's 500 stock-index, are trading under $5 while three—eTrade (ETFC), American International Group (AIG), and Tenet Healthcare (THC)—are under $1. That's why more companies are expected to try an old trick: reverse stock splits. Time Warner Cable is slated to complete a reverse-stock-split offering by Mar. 12 as part of its separation from Time Warner (TWX), which should wrap its own reverse split by Mar. 27.

Companies use reverse splits when stocks are depressed as a way to boost share prices while decreasing the number of shares outstanding. Time Warner and Time Warner Cable's reverse splits involve exchanging three shares for one, which will then trade at a higher price. That means if you own 3,000 shares of either entity, you'd get just 1,000 shares after the reverse split. Naturally, your stake will be worth the same amount, but companies as well as investors place a psychological premium on a higher stock price.

In bull markets, investors often bid up a stock when it announces a conventional split. Conversely, research shows a reverse split is a signal to dump a stock. A 2008 study of 1,600 companies that did reverse splits found the typical stock underperformed the broad market by 50% on a risk-adjusted basis during the three-year period after the action. "Reverse stock splits are a strong indicator the company is going to be a significant underperformer during the near future," says Jim Rosenfeld, co-author of the study and an associate professor of finance at Emory University's Goizueta Business School in Atlanta.

"A Desperate Move"

In other words, the bad things that are happening to a company cannot be reversed once the stock price is higher, says April Klein, an associate professor of accounting at New York University's Stern School of Business in New York and another co-author of the study. "It's usually a desperate move," Klein says. (Rosenfeld and Klein's 2008 paper, "Return Performance Surrounding Reverse Stock Splits: Can Investors Profit?" tracked companies from 1962 to 2001. It was co-authored by Seoyoung Kim, a PhD student of finance at Goizueta.)

Desperate move or not, reverse stock splits are a sign of dismal stock markets. After the tech bubble burst from 2000 to 2001, 39 companies orchestrated reverse stock splits. Since 2008, 75 companies have already used this cosmetic maneuver, according to an analysis 6,755 companies conducted for BusinessWeek by Thomson Reuters.

Why are companies so concerned about boosting their stock price? Part of it is technical, and part of it is due to the stigma of low single digits. In the past, getting delisted from the major stock exchange was a prime motivator for a reverse stock split, Rosenfeld says. But the New York Stock Exchange temporarily altered its rules this year, giving companies until June 30 to get share prices above $1. In January, the NYSE also temporarily lowered minimum global market capitalization requirements, from $25 million to $15 million. The Nasdaq also has temporarily suspended its listing requirements.

Index More Important than Price

The notion that major institutions must sell a stock if it goes below $10, $5, or even $1 seems to be an urban myth. The largest mutual fund companies, including T. Rowe Price (TROW), say no such rules exist for their funds. At Vanguard Group, "we'll own the stock as long as it remains in [an index] fund's target benchmark," says spokesman John Woerth. And there is no single threshold among the company's actively managed portfolios, he says.

The Council of Institutional Investors is unaware of rules requiring institutional investors to sell equities when they dip below a certain price. Indeed, that's the case at major pension funds, such as California State Teachers' Retirement System (CalSTRS). "CalSTRS has no rule to sell below a certain amount," according to a spokeswoman.

So that leaves the psychological barrier of a sub-$5 share price, which is a huge one from a confidence perspective, says Anton Schutz, manager of the Burnham Financial Services Fund (BURKX). "People look at low stock prices, and think 'Wow, this company must be in trouble,'" Schutz says. That's why some of the megabanks, including Citigroup, (C) may try to engineer a reverse stock split in the coming months, he predicts. A reverse stock split is "financially meaningless, but the optics are better," Schutz adds.

Tough to Sell Short

While reverse stock splits don't have a stellar track record, shorting companies who complete a reverse stock split is often futile. The short interest in these stocks is "essentially zero" two-thirds of the time in three-year period following the split because broker-dealers don't have them in their inventory. "You can't borrow them to sell them short," Goizueta's Rosenfeld says. "Even if you expect [the stock price to go down], you really can't profit from it."

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