Reverse stock splits mean trouble's brewing

No one else in the family cares as much as I for Paula’s Perfect Pie, so the whole thing is mine. I’m not greedy - that’s just the way it works out.

So the whole pie is mine to eat. I can pick at it a slice at a time or, if I were really gluttonous, eat the whole thing at one sitting. Regardless of how it is consumed, it is never more than a single, whole pie. “Duh,” you say? Of course, it is never more than a whole pie.

There’s a moral, nah, make that an axiom, for this pie story. No matter how you slice it, you never have more than you started with.

And so it is with stock splits, a corporate decision that, when announced, sometimes gets investors excited to the point of buying the stock for no other reason than that it is splitting.

Does it make sense? Not really. Say you own 100 shares of United Frumply and it splits 2 for 1. Now you have 200 shares. Great, you have twice as many.

But you also have a price that is adjusted for the split. If your original 100 shares were worth $100 each they had a total value of $10,000. They split 2 for 1 and you have twice as many. But the price is adjusted by dividing it by 2, resulting in a price per share of $50, so your 200 shares are worth $10,000. Bingo! Right back where you started. No matter how you slice the pie, it doesn’t get any bigger.

What, if anything, is the value of a stock split? As far as I am concerned, it is twofold.

One, it reflect management’s positive outlook, as companies don’t declare splits if they think the price of the stock is likely to decline substantially. Two, it has the potential to broaden the ownership, simply because there are investors who avoid buying stocks at high absolute prices. (This one is not rational, as a percentage return is a percentage return whether it is on a $5 stock or one that sells for $50, but there are more investors that are willing to buy 100 shares of a $5 stock than will buy 10 shares of a $50 stock.) Ah, the psychology of it all.

There is, however, a caution you should be aware of when it comes to stock splits. It’s called a “reverse split,” and it is a warning sign that a company is in trouble - usually serious trouble. Reverse splits are just as the name implies: They shrink the number of shares you own. Because it does the same for all stockholders, your percentage ownership of the company remains the same. That’s not the problem. Reverse splits are used to increase the per share price of the issues in order to meet listing requirements established by the various markets (NYSE, AMEX, Nasdaq).

In effect, the management of the company is doing everything it can to keep the stock trading in an active market place. Somewhere out there is a company that has executed a reverse split, actually turned the company’s financials around, maintained its listing on an exchange, and ultimately thrived. I just don’t know of one.

From bad experiences in the past, I am of the very firm opinion that if an investor owns a stock that announces a reverse split, it should be sold immediately.

Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.