When Is A Reverse
Split Good News?
The Dynamic Wealth Report
June 25, 2010
by Corey Williams, Editor
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?
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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.
• Pinnacle Financial Partners (PNFP) was upgraded by
Wunderlich this week. They now have a buy rating on the stock. The bank
has the ninth fastest average long-term earnings growth rate in the
banking industry.
• Research In Motion (RIMM) was downgraded to Neutral by
Robert W. Baird this week. The smartphone maker’s flagship product the
BlackBerry is losing market share to the iPhone and Android-based
phones.
• Stifel Nicolaus started coverage on Dell (DELL)
this week with a buy rating. The PC maker issued disappointing earnings
guidance earlier this week.
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