Naked Brand Group, Inc. (NAKD)

[beenhadbefore]

Citigroup reversed now its $70

Can reverse stock splits be a signal to sell?

If a company in your investment portfolio announces a reverse stock split, you might wonder if or how you should react before the split takes place.

"Just as stock splits are a sign that a firm is thriving, reverse stock splits are an admission of a struggling firm — a huge red flag," said Robert Johnson, a chartered financial analyst and CEO at Economic Index Associates, in an email interview.

A 2008 study that looked at reverse stock splits from 1962 to 2001 backs up Johnson’s assertion. The study, conducted on behalf of the Financial Management Association International, found a "significant downward price drift and significantly lower earnings and operating cash flows" in the three years after a company’s reverse stock split. This, the researchers said, suggests the market tends to underestimate how poorly companies will perform post-split.

“Just as stock splits are a sign that a firm is thriving, reverse stock splits are an admission of a struggling firm — a huge red flag.”

Robert Johnson

Steve Sosnick, chief strategist at Interactive Brokers and a former trader with Lehman Brothers and Morgan Stanley, says investors would likely see the warning signs early on.

"Presumably, an investor would have noticed that the stock in question was already acting poorly, but if not, the announcement of a reverse stock split is usually yet another significant clue," Sosnick says.

But there are, of course, outliers. Citigroup is often used as an example: In 2011, the company underwent a 1-for-10 reverse stock split (and also reinstated its dividend) that brought its shares up from around $4, technically considered a penny stock, to over $40. Though the share price has bounced around over the years, it never again veered toward penny stock territory and was trading in the $70 to $80 range before the pandemic hit in 2020.

The split came after Citigroup reported in 2010 its first year of four profitable quarters since 2006, highlighting an important consideration: If a company is improving its earnings and cash flow, and is committed to making further improvements in the future, a reverse stock split may not spell disaster. But that may be the exception, not the rule.