When Is A Reverse Split Good News?

| June 25, 2010 | 0 Comments

For most CEOs, a reverse stock split ranks right up there with getting a root canal.  It’s a sign something’s gone horribly wrong.  And it’s never pleasant.

We’ll often see reverse stock splits from distressed companies and those on the verge of bankruptcy.  When they finally see their stock prices fall into penny stock range, they’re forced to take action.

The reverse split does two things.  It reduces the number of shares outstanding.  And it increases the share price.  But most people don’t realize it doesn’t change anything about the company’s fundamentals.

For example, here’s how a 1 for 20 split works.  Each investor receives 1 new share for every 20 shares they own before the split.  And the stock price will be worth 20 times as much after the split.

As I said before, a reverse split doesn’t impact the value of your position. Owning 20 shares of a $1 stock is the same as owning 1 share of a $20 stock.  In each case, the shares are worth $20.

The big question is why do companies do it?

One reason companies perform a reverse stock split is purely psychological.

Many investors don’t want to own penny stocks.  There’s a belief higher stock prices equate to a more stable company.  Obviously a stock’s price is not necessarily a reflection of a company’s stability.  But a reverse split can at least give the perception of stability.

Another reason we’ll see a reverse stock split is to avoid being delisted.

You see, the major stock exchanges like the NYSE and NASDAQ have a minimum stock price requirement.  If a stock’s price falls below the required level, they run the risk of being delisted.  Getting delisted can be catastrophic for a stock.

Once a stock is delisted, some institutional investors are no longer allowed to own the stock.  They’ll have to sell their shares.  This can create heavy selling pressure on the stock.  A reverse split can often protect a stock from this downward spiral.

Clearly, a reverse split usually doesn’t happen because the company is doing great.  More often than not, it’s a good reason to avoid buying a stock.

But it’s a completely different situation when an ETF has a reverse stock split.  In fact, a reverse split can be helpful to an ETF.

Even though an ETF trades throughout the day like a stock, an ETF is a fund, not a company.  A reverse stock split has an entirely different meaning for a fund than it does a stock.

Remember, an ETF’s price is determined by the value of the underlying basket of stocks.  There’s no relationship between a fund’s health and the share price.

You might be surprised to hear the fund’s price is mostly irrelevant.  It’s determined by where the ETF provider initially set the price when the ETF began trading.  And the price movements of the underlying stocks since.

When you add in the leverage, some ETFs and inverse ETFs use to deliver 2 or 3 times the movement of the underlying stocks.  It’s no surprise they can trade down to a fraction of their original price.

An ETF’s lower price isn’t a problem by itself or a reflection of the fund’s health.  However, a low price can increase the funds tracking error.

Tracking error is when the value of the underlying assets (or NAV) differs from the price of the ETF.  When the discrepancy between the NAV and the price becomes too big, it makes the ETF ineffective.

And who’s going to invest money in an ETF that doesn’t do what it’s supposed to?  I certainly won’t!

When an ETF undergoes a reverse stock split, it’s an adjustment to protect shareholders from NAV discrepancies.  Not a sign the fund has failed or done anything wrong.

In a few weeks, we’ll see four leveraged bear ETFs from Direxion undergo a 1 for 5 reverse split.  They are the Direxion Daily Energy Bear 3x Shares (ERY), Direxion Daily Real Estate Bear 3x Shares (DRV), Direxion Daily Small Cap Bear 3x Shares (TZA), and Direxion Daily Technology Bear 3x Shares (TYP).

But don’t worry, the funds aren’t going anywhere.  They’re just adjusting them to make them more efficient at their job.  And that’s good news.

Tags: , , , , , ,

Category: ETFs

About the Author ()

Corey Williams is the editor of Sector ETF Trader, an investment advisory service focused on profiting from ETFs and the economic cycle. Under Corey’s leadership, the Sector ETF Trader has become one of the most popular and successful ETF advisories around. In addition to his groundbreaking service, Corey is the lead contributor to ETF Trading Research, where he shares his insights about ETFs and financial markets on a daily basis. He’s also a regular contributor to the Dynamic Wealth Report and the editor of one the hottest option trading services around – Elite Option Trader.

Leave a Reply

Your email address will not be published.