Academic journal article Financial Management

Return Performance Surrounding Reverse Stock Splits: Can Investors Profit?

Academic journal article Financial Management

Return Performance Surrounding Reverse Stock Splits: Can Investors Profit?

Article excerpt

We examine the long-run return performance of over 1,600 firms with reverse stock splits. These stocks record statistically significant negative abnormal returns over the three-year period following the month of the reverse split. The sample firms experience poor operating performances over the four years that include and follow the year of the reverse split, which suggests informational inefficiencies. Because these stocks have unique financial characteristics', we also show that they would be very difficult to sell short. Thus, arbitrageurs would be restricted in their ability to earn abnormal profits, even if they correctly anticipated a price decline.

We begin our study by examining the long-term stock and financial performances for a sample of 1,612 firms following reverse stock splits. Our study period covers the 40 years between 1962 and 2001. When we compare our sample firms to firms with similar characteristics, we find a significant downward price drift and significantly lower earnings and operating cash flows (OCF) over the three years following the ex-split date. (1) These results suggest that the market underestimates the future poor performances of reverse stock splits and that investors should be able to exploit this market inefficiency by short-selling these stocks. However, institutional restrictions on short-selling and other transaction costs related to the unique characteristics of these stocks significantly curb investors' ability to earn abnormal profits from these stock movements. Thus, we conclude that while reverse splits are informationally inefficient, investors' opportunities to reap abnormal returns from this information are limited. Following Fama (1970) and Jensen (1978), we view this scenario as being consistent with market efficiency.

Our sample shows that reverse-split firms are nonrandom, in that they come primarily from the extreme left tails of the distributions for stock price and firm size. We demonstrate that these firms have liquidity and financial distress characteristics that prevent investors from reaping abnormal profits despite expectations of a poor market performance. During the month of the ex-split date and for three years following this month, our sample issues have significantly lower monthly short interest compared to firms without reverse splits. Further, the inability to short-sell is greater for sample stocks with an ex-split price less than $5.00. We also find that when we divide our sample into stocks above and below an ex-split price of $5.00 per share, only the smaller-priced subsample earns significantly negative abnormal returns. Taken together, the underperformance and short-selling findings suggest that investors are restricted in their abilities to earn economic profits after the ex-split date. Thus, despite the systematic underperformance after the ex-split date, we conclude that these results are consistent with an economically efficient market (Fama, 1970; Jensen, 1978).

We also find that the sharp decline in stock price on the day of the reverse split can be partly explained by a reduction in transaction costs on the ex-split date. We attribute this phenomenon to the nature of our sample, which is that most reverse splits are priced under $1.00 per share prior to the ex-split date. We find that the magnitude of the ex-split date stock decline is directly related to the size of the stock split, which in turn is directly related to the reduction in the stock's relative bid-ask spread. Accordingly, investors who sell prior to the ex-split date to avoid the negative return on that date will incur higher transaction costs to liquidate their positions. Once again, we conclude that despite the significant negative abnormal return recorded on the ex-split date, the market acts in an economically efficient manner.

Our findings and interpretations have implications for other long-run performance studies, since informational inefficiencies (e. …

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