By WallStreetDaily.com

Conventional stock splits have fallen out of favor.

Yet reverse stock splits are exploding.

Is the market trying to send us a cryptic message — that is, through the way CEOs are managing their share price?

Let’s peel back the layers a bit…

A straight-up stock split is a purely bullish event, without exception.

The latest traditional splitters are Copart Inc. (2:1), German American Bancorp (3:2) and Heico Corp. (5:4).

Check back on these companies in six months and it’s likely they’ll have outperformed the benchmark indexes.

A reverse stock split, however, is done for a host of reasons — and not all of them are good.

The latest reverse splitters are AmpliPhi Biosciences Corp. (1:10), Dryships Inc. (1:4) and Immune Pharmaceuticals (1:20).

To understand what lies ahead for the reverse splitters, we must sharpen our lens.

I asked my senior analyst, Martin Hutchinson, to solve the stock split conundrum for us.

If the market is indeed sending as a message, you deserve to know what it is.

Hutch’s full report is below.

Ahead of the tape,

Louis Basenese
Chief Investment Strategist, Wall Street Daily

Question: Martin, you’ve agreed to help us compile a library of the most important investment catalysts. These are baseline concepts that every investor should know. Today, we’ll be discussing stock splits. So let’s jump right in now, Martin. Let’s start at the beginning. What’s a stock split?

Martin Hutchinson: There are two types of stock splits. You can have a stock split, or you can have a reverse stock split.

In a stock split, a regular type, they offer you a deal whereby one old share gets you two new shares, five new shares, 10 new shares. So you end up with more shares than you started with… twice, five times or 10 times as many. These are used when the share price has risen too high and made it unattractive for retail investors to participate.

For example, you’ve got Amazon and Google both near $1,000. A hundred shares for normal round lots in those cost you close to $100,000.

Ideally, you want a share price in double digits — maybe the lowest double digits, $20s and $30s. That attracts small investors, who can buy round lots of 100 shares and feel like they’re probably betting on a level playing field with the big guys.

If you’re a company trying to attract a full range of investors, you want a share price that’s somewhere in that $20–30 range. So companies, where their shares are trading at $100 or $200, will often do stock splits to bring the share price down to $20-something. Because if you start with one share at $200 — and then you do a 10-to-1 stock split, what you end up with is 10 shares at $20.

By and large, stock splits are a bullish signal that management thinks the business and the share price are going to go on growing. You wouldn’t do a stock split if you thought the price was then going to decline. Investors by and large take it as a bullish signal, so you’ll find that the share price generally goes up around a stock split.

When it’s announced, it’ll go up a bit. And then it maybe go up more as the stock is split and more retail investors come in at the new $20 or $30 price.

Question: So say you’re holding a stock, Martin, and you’re already a shareholder. Then they announce a stock split. While it may seem like your share price has just gone down, this is actually really favorable for you as the shareholder.

Martin Hutchinson: Yeah, it’s great. You’ve ended up with, firstly, many more shares. And secondly, usually with a higher share price — adjusted for the increased number of shares. Your $200 one share will go to perhaps 10 shares at $25 each. So you’ve ended up with a package worth $250.

Question: Now, all that’s happening really is there are just more shares out there in the market. Is that what’s happening when the stock splits?

Martin Hutchinson: That’s really all that happens, yes. There’s no cash changing hands at all. It’s just that there are now more shares. Of course, the liquidity is thereby increased often. If you’re Amazon or Google at $900 and a market capitalization of $500 billion, you don’t have to worry about liquidity. But normal folk do. So a stock split increases it.

Question: Now, in my experience I’ve never seen a stock split that was actually having some problems with their core business also. I’ve never seen a share price move down from, say, $200 to $100, and then all of a sudden the company decides to split shares.

Is that why you’re saying it’s a bullish indicator? This is typically exclusive to companies that are growing their earnings base?

Martin Hutchinson: Yes, that’s right. Management thinks there’s some growth there. It’s going to go on going up. And they want to broaden the shareholder base. So it’s typically an optimistic signal. People see it as an optimistic signal.

They say, “Management knows more than we do about the company. They’re being optimistic, so we should be as well.” So it’s just good news all round.

Question: Yeah. I think it plays to just the nature of human beings, right? If you’ve been eyeing a company that’s trading for $100 a share, you might say, “You know what? I wish I would have caught that ride.” But if they split and suddenly the company’s trading for $20 again, I think the natural human behavior might be like, “Well, this is my time to get in.”

Martin Hutchinson: Yeah, absolutely. That increases the bullishness as well, because you’ve got new investors coming in.

Question: All right, cool. I know you wanted to cover two types of stock splits. Let’s move on to our reverse stock splits.

Martin Hutchinson: Let’s move on to reverse stock splits. You’d think they were the exact opposite, but their effect is not quite the exact opposite.

In a reverse stock split, you take five old shares, 10 old shares and 20 old shares — and you end up with one new share.

You think, “This is a lousy deal. Here I have 10,000 shares, and suddenly they do a 1-for-10 reverse stock split, and I’ve only got a thousand new shares.”

It’s often used when the share price has fallen too low. Very often, for example, when the share price has fallen below a dollar.

The New York Stock Exchange won’t list you if the price is below a dollar for six months. So if you’re trading at 50 cents and you do a reverse stock split 1-for-10, you are then trading at $5, and that’s good news.

Institutions often won’t buy shares priced below $5 as well. So this is the reverse of the other way.

With a stock split, you’re trying to get more retail investors in. Here, with a reverse stock split, starting with a stock trading for 50 cents, you’re trying to get some institutional interest.

You’d think it was a sign of trouble, because if a stock split’s good, then a reverse stock split should be bad. Psychologically, it is a bit.

For an industrial company, it generally is a sign of trouble. The reason the thing’s trading at 50 cents is the business has shrunk and become less profitable. And they just want to get the share price up to a reasonable level that people will look at it again.

They’ve probably done too many share issues and diluted it. Therefore, for an industrial company, it’s a bearish sign. The price may continue to decline after the reverse split.

For mining companies in particular, it is often a sign that the company has issued too many shares. But issuing too many shares may have been to do something useful. For example, if you’ve got a gold mine and it takes a billion dollars to build, you’ve got to raise the billion dollars. You go out and raise $600 million in debt and then you’ve got the gold mine 60% built. You’ve still got to put the other $400 million in to get anything out of it.

So very often, mining companies will do very dilutive share issues to get the gold mine finally over the top, so to speak, and get the last bit done.

In that case, a reverse stock split — once the mine’s completed and open — can be very good news. Because it brings the share price back into something sensible.

I mean, for example, I had a company called Endeavour Mining, which is EDV on Toronto, or EDVMF at the OTCBB, and that was trading at 50 cents. It had issued too many shares. It did a 1-for-10, which made the share price $5. But since then the price has traded up from $5 to about $17.

So the reverse stock split genuinely did put the share back in the sweet spot of the bigger institutions and the more conservative retail investors. It was a decent company. It was making money, once they got the mine open. So it was good news all around, really. The reverse stock split worked.

Question: Another good-news-all-around situation with reverse stock splits: As you know, I cover the technology sector a little more closely than you do. Companies are foregoing the IPO process, just because it’s clunky. IPOs are not in vogue like they once were. And honestly, it takes a lot of cash to launch an IPO. So there are companies that are just going the reverse merger route.

What they’re doing is taking dying companies, usually penny stocks that have issued a ton of shares, bringing them back to center a little bit by using a reverse stock split. And they’re relaunching a new business right out of that same tickers.

Martin Hutchinson: Yeah. That makes a hell of a lot of sense… You’re quite right… because you’ve got a company that’s not worth anything. It gets bought for not very much. Then, with the reverse stock split, you’ve got it back where people want to buy it, and you’ve got a story.

I know mining companies that have done that as well. For these odd businesses like mining and technology, it’s a technique that’s certainly not obviously bearish. It may very often be bullish.

Question: I think the takeaway here is that in the two types of stock splits, a traditional stock split really can only be viewed as a bullish maneuver by a company. It’s done by companies that are growing. They want to continue to grow and they want to make their share price a little bit more attractive to your regular investor.

Reverse stock splits, I think you’ve got to kind of peel back the onion a little bit. Do you think that’s a fair takeaway?

Martin Hutchinson: That’s absolutely a fair takeaway. You’ve got to look more closely with a reverse stock split. But it can be bullish, also.

Question: Well, thanks for your time today, Hutch.

Martin Hutchinson: Great to be with you.

Question: This is Wall Street Daily signing off.

Smart investing,

Martin Hutchinson
Senior Analyst, Wall Street Daily

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