Reverse stock splits are the kiss-of-death for stocks. After more than 25 years of trading, I can honestly think of just a handful of stocks that pulled off a reverse split and lived to tell the tale - THQI comes to mind (and they are bankrupt now). More often than not, the company is in terminal decline and a reverse split is just an indicator of death throes. DryShips is embarking on, yet another, reverse split. Some will, of course, view the drop in DryShips (NASDAQ:DRYS) as a buying opportunity. Rest assured - it is not.
What is a Normal Stock Split vs. a Reverse Split?
Normal Split - People like shares that are "cheap." If I were to show a random person a stock and tell them "the price per share is $1,000" they would respond, "Wow! That's expensive!," but without knowing the underlying assets and prospects of the company this could, in fact, be cheap. The psychology of people's thinking is they like to buy things that they consider a "deal" or low priced. If you make your share price $10-$50 people feel like they are getting more "bang for the buck."
Reverse Split - A reverse split is when shares are taken and clobbered together. Example: If a company announces a 1 for 8 split and you own 800 shares at $1, you now have 100 shares but at 8x the price. Nothing has changed in the big picture. The math has shifted a little bit - no fundamental change has occurred.
Example of a 1 for 8 Reverse Split:
Before - 800 shares @ 1 dollar = 800 bucks.
After - 100 shares @ 8 dollars = 800 bucks.
What Motivates the Company to Reverse Split?
1. Mutual funds and such are wary to invest in low-priced stocks because it's one thing to put money in a solid company like Cisco vs. putting capital in a risky penny stock. Some have minimum share price requirements such as $5. If the stock goes below that price, they are barred from owning it.
2. The company wants a "respectable" stock price in order to keep the big funds in and the price supported.
3. Companies want to stay listed on the big exchanges and not be cast off to the pink sheets. The larger exchanges require certain stock price levels to be meet. If kicked off the big exchanges, some funds might be forced to liquidate, driving the share price even lower. DryShips trades on the NasdaqCM market thus the 5500 Section A, Rule 2 is the biggest concern for DryShips. This is one of the reasons they did a reverse split - to avoid a delisting notice once they went under one a share:
Why Avoid Delisting?
As fast as DryShips has been plummeting in share price, the company realized they were going to hit the $1 mark and get hit with a delisting notice. Now you might be saying "A delisting? That does not sound so bad."
Trust us, it is very bad to get delisted. To borrow from one of my old articles, where we wrote:
"The stock (according to this research paper) should experience a 20% drop in stock price on average on day 1 of delisting, followed by a general downward slope over the next 60 days.
(Chart showing average reaction to delisting over 60 days)
The paper goes on to provide some interesting details on what happens to stocks once delisting occurs.
"We examined 1098 Nasdaq firms delisted in 1999-2002 that subsequently traded in the OTC Bulletin Board and/or the Pink Sheets. Market quality deteriorates significantly after delisting: share volume declines by two-thirds, quoted spreads almost triple from 12.1 to 33.9 percent, and effective spreads triple from 3.3 to 9.9 percent. Volatility triples from 4.4 to 14.3 percent, but quickly reverts to slightly-elevated levels. Deterioration is significantly larger for more severe violations (e.g. bankruptcy) than for lesser infractions (e.g. minimum bid price)."
Outcomes of a Reverse Split
A reverse split signals that things are horribly amiss at a company. Take the Pepsi challenge and go to Google and look for stocks that did a reverse split and see what they did long term, or save some time and look at this theses. On page 90, we see that reverse splits result in very poor returns, generally growing worse the farther out you go in time.
Example: On the left is the rate of return that was yielded, on the top is the time frames used, and the middle is the odds of it working out to the return percent on the left. So looking at the first example, at 30 days after a reverse split, a mere 33% of the time the stock returns 20% and so on.
Not the best odds in the house at a 67% chance to lose and it only gets worse with time or higher return percentages. We could do better at a craps table if we lay odds.
Avoid reverse splits and delistings. The stock market is quite wide and deep. Value can be found elsewhere. If you just have to gamble, wait for the stock to complete the reverse split and then buy calls or sell puts to go long or short. It is a much cheaper way to play the volatility you are betting on. Your local broker (or a good starter book on options) can tell you how to do it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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