Many investors see reverse stock splits as a last resort to keep listings on the major stock exchanges.  You have to pay close attention to these red flags, since reverse stock splits may be a sign that the company is going under, taking your investments with it.

Reverse split dynamics

A reverse split is usually enacted to keep the price of stock above a certain level (usually one dollar), preventing it from being delisted by the exchange.  Usually, companies will combine enough shares to get to the $5 mark.  This can be a warning flag to investors since a good portion of these stocks end up trading lower after the split occurs.  Many investors then see their holdings reduced significantly in just a few months’ time after a reverse stock split. 

When the market bubble burst, many companies saw big losses and tried to recuperate by doing reverse splits.  Many of these companies are no longer found on the major stock exchanges despite their best efforts.  A few were able to prosper, but most saw losses of 37%, the amount that stocks on average tend to decline by three years after a reverse split.  Small companies do the worst, and they may fall as much as 44% in the three years after the reverse split occurs.

Many stocks continue downhill after reverse splits simply because they were in financial trouble in the first place. A stock does not start to trade under a dollar unless there is something seriously wrong with the corporate fundamentals.  They can be a definite warning flag that something is not healthy with the business.

Some companies will try to cite good reasons for reverse splits.  Fund managers may ignore stocks under $5 since they appear risky.  Investors also usually cannot use margin to buy stocks under $5, and many brokerages will not push them.  This can limit demand.  Other companies may simply have too much stock lying around from the bubble days when everyone was buying.

To short or not to short

Shorting reverse splits is not always the best move.  On rare occasions, a stock will shoot up after a reverse split.  There are several factors that often determine if shorting the stock may be a good move for your portfolio.  Generally, do not short companies that have improving prospects at the time of the split.  Sometimes a change in management is all it takes to get a company turned around and making a profit again. 

Watch the company’s sector; if the entire sector is having problems, then it may be a good investment to go short.  On the other hand, if the overall sector is healthy growing, you probably do not want to short the particular stock. Look at the cash flow a company has as well.  If a company has enough cash flow to survive, it may make it through a reverse split. 

Watch for companies that may only be undergoing a split to make their stocks look better.  A company may do a reverse split to bring stocks up to well over the $5 mark – for instance from $5 to $20 a share.

If a stock is about to go through a reverse split, it is a definite sign that you should take notice of how it may impact your portfolio.  Often, it is an attempt to make things look better than they really are, and it signals a good time for you to go short or get out entirely.