Do Reverse Splits Ever Work?

Source: Rafael Matsunaga, Flickr.

Stock splits should theoretically have no impact whatsoever on a stock's price. Yet when a stock performs well and announces a stock split, investors often get even more optimistic about its prospects and bid shares higher. By contrast, when companies go through tough times, they often have to resort to reverse stock splits in order to bring their share prices up from rock-bottom levels.

Given how many companies execute reverse splits only to find themselves still in major financial trouble, some investors equate reverse splits to a death sentence for a stock. Yet over the course of history, you can find at least a few companies that have proven to be the exception to that rule.

Why companies do reverse splits Over time, numerous companies have resorted to reverse splits in order to lift their share prices. One common reason is to avoid getting delisted, as some major exchanges require that share prices stay above $1 to keep from triggering delisting guidelines.

For instance, many believed now-bankrupt RadioShack might implement a reverse split in order to keep the New York Stock Exchange from taking the stock off the Big Board, while some have pointed to Arch Coal's latest struggles to stay above the $1 mark as evidence that the company should consider a reverse split. Other companies prefer to do reverse splits to keep from looking like penny stocks.

Of course, when you look at it from an economic standpoint, splits shouldn't matter to a company's fundamental value. Whether regular or reverse, a split simply changes the number of shares outstanding. Offer two shares for every one existing share, and the price for each should get cut in half. Issue one new share for every 10 currently outstanding, and each share's price should multiply by 10. The net value should remain the same.

Source: AIG.

Nevertheless, reverse splits have not worked out well for many companies that have used them in the past. Sun Microsystems, for instance, did a 1-for-4 reverse stock split back in November 2007, but after just a year, the shares had fallen 85% before bouncing in the wake of Oracle's (Nasdaq: ORCL) takeover of the tech giant. Even after paying a premium to the then-prevailing share price, longtime Sun shareholders didn't come close to recouping their losses.

The financial crisis has some of the most graphic example of reverse splits gone bad. In 2009, AIG did a 1-for-20 reverse split after shares had flirted with the $1 mark for the better part of a year following the market meltdown in 2008. With the help of extensive bailouts, the company has survived, but even so, the stock remains down more than 95% from where it traded in mid-2007, after adjusting for the split.

Surprises from reverse splits Occasionally, though, a reverse split works out well. Consider these three examples:

  • In mid-2003, did a 1-for-6 reverse stock split, lifting its stock price from around $3.50 per share to $22, as many investors believed that the William Shatner-led Internet travel service would fade away with so many other dot-com companies. Now, 12 years later, the stock trades above $1,200 per share, giving long-term investors a 50-bagger with room to spare.
  • In 2000, Laboratory Corp. of America did a 1-for-10 reverse split after having seen its stock stuck in single digits for more than five years. Within two years of the reverse split, LabCorp had not only recovered, but it had also done two separate 2-for-1 regular splits, and the stock now trades for six times its split-adjusted price immediately after the reverse split.
  • Corrections Corp. of America traded as low as $0.60 per share in 2001 before reverse-splitting 1-for-10. Since then, the private prison-services provider has seen its stock jump more than tenfold, with two regular splits helping to drive the company's total return higher.

Source; TheTaxHaven, Flickr.

Be smart about stocks It's important to realize, though, that these stocks aren't typical. Past research has shown that most stocks underperform the market following a reverse split. That isn't surprising. After all, a company that sees its stock fall so far usually has to have gone through a tough period. The split does nothing to fix any internal problems the company has, and only a few manage to solve their difficulties and achieve permanent growth trajectories. Those few winners can't make up for the weight from their failing counterparts.

Moreover, companies that do reverse splits on their stocks make themselves a target for bearish speculators. Because of their poor reputation, reverse splits make many investors flee stocks, even if their fundamentals improve. That can give smart investors great opportunities, but they're few and far between.

Companies that need reverse splits typically start with a big disadvantage. Only very rarely can those companies give investors the huge returns they want in top investments.

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Dan Caplinger owns shares of American International Group and Priceline Group. The Motley Fool recommends American International Group and Priceline Group. The Motley Fool owns shares of American International Group and Priceline Group and has the following options: long January 2016 $30 calls on American International Group. Try any of our Foolish newsletter services free for 30 days.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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