In a filing with the SEC last week, Citigroup said it is considering a reverse stock split as part of its effort to convert preferred shares (take priority over common shares on earnings and assets in the event of liquidation) to common shares.
What is a reverse stock split?:
It is a reduction in the number of a corporation’s outstanding shares and a corresponding increase in the value of those shares. For example, if you own 200 shares of company XYZ @ $5 per share, a 1-for2 reverse stock split would result in your owning 100 shares @ $10 per share. The value of your holding remains the same:
200 x $5 = $1000
100 x $10 = $1000
Reasons why reverse stock splits are done:
1-It makes corporate shares look more valuable although there has been absolutely no change in real worth.
2- Many institutional investors have rules against purchasing a stock whose price is below a certain minimum level, $5 perhaps. Citigroup now falls into that category.
3- Fear of being delisted is another possible reason. If a stock falls below a certain price, it may no longer meet the exchange requirements and face delisting or being removed from trading rights on that particular exchange.
4- Reduce the number of shareholders is a rare but possible explanation for a reverse split. If the split results in a shareholder owning less than a minimum required number of shares, they would receive a cash payment and no shares of stock. This may be benficial to a company seeking to be put in a different regulatory category such as an S-Corp which is required to have less than 100 shareholders.
Let’s take a look at a chart of Citigroup as of 3-24-09:
You can see that Citigroup went from a $50 per share stock to a $3 per share equity. To get this to a somewhat cosmetically acceptable scenario, a 1-for-10 split would be necessary. This would elevate the share price to $30 per share. If you owned 1000 shares @ $3 before the split, you would own 100 shares @ $30 after the split.
What does a reverse split signal? :
In 2008, Jim Rosenfeld, an associate professor of finance at Emory University’s Goizueta Business School in Atlanta, did a study involving 1600 companies that did reverse stock splits. He found that the typical stock in his study underperformed the market by 50% on a risk-adjusted basis during the three year period after the action. His conclusion:
“Reverse stock splits are a strong indicator the company is going to be a significant underperformer during the near future.”
What if I sold covered call options on such a stock? :
Perhaps you were out partying the night before and had a bit too much to drink. You woke up the next morning and omitted your first cup of high-octane coffee that might have brought you out of your fog. Through no fault of your own, this drug-induced state causes you to ignore all the fundamental and technical requirements of our system. Common sense is also tossed out the window as you rationalize that Citigroup cannot possibly go any lower than $30! Okay, that’s all water under the bridge. Here’s an example that is simple to follow:
- You sold 10 contracts of the $5 call.
- After a 1-for-10 split that would change to having sold 1 contract of the $50 call.
- Ticker symbols would change but the expiration date remains the same as does the premium initially collected.
When the numbers don’t break down as perfectly as these, it is much more complicated. The best way to handle these scenarios is to contact your broker or the CBOE Exchange. The split information can be obtained online as follows:
You can also call the CBOE (Chicago Board Options Exchange) for free information:
For more information on conventional stock splits, here is a link to an article I published a year ago:
I also devoted a full chapter in my book, Cashing in on Covered Calls, to the subject of stock splits.
* The Blue Collar System will force you to avoid all stocks that are forced to resort to reverse splits. They simply will never meet our fundamental and technical criteria.
Industry in the Spotlight:
Great performing stocks can oftentimes be located by first identifying those industries that have been favorites of the institutional investors. One such group in the Chemical Manufacturing-Fertilizer Group. Here is a chart showing a definite reversal of a downtrend for the last several months:
Three stocks that are performing well within this industry are TRA, SQM and CF. Check them out and see if they belong on your watchlist.
Last weks economic news:
The final revision of the 4th quarter 2008 GDP was down 6.3%, the worst since 1982. However, there was good news on the economic front last week. February exisitng home sales rose 5.1% from January and new home sales were up 4.7%. Consumer spending was up for the second straight month along with an increase in prices, allaying fears of deflation. February durable goods orders were also up for the first time in seven months. For the week, the S&P 500 was up 6.1% for a year-to-date return of – 9.0%.
My best to all,
Alan ([email protected])