Why Citigroup's Reverse Split Is a Signal to Dump the Stock

Citigroup's (NYSE: C  ) 1-for-10 reverse split on May 9 is one more reason to sell the stock. In theory, it should improve demand for the stock, which economics 101 suggests should drive prices higher. But studies show stocks that undergo reverse splits underperform the market both near-term and long-term.

But why might Citigroup be reverse-splitting in the first place? Many institutional investors -- e.g., mutual funds and pension funds -- have investment policies that prohibit them from owning stocks priced below $5.00. Citigroup stock plunged below $5.00 in January 2009. Since then, it has closed at or above $5.00 only during two brief periods, first in August 2009 and again in January 2011. It has been trading between about $4.40 and $4.60 since mid-March.

As you can see, Citigroup's institutional ownership is lower than other large U.S. banks:

Stock

Institutional Ownership

Citigroup 56%
Bank of America (NYSE: BAC  ) 60%
Goldman Sachs (NYSE: GS  ) 69%
Morgan Stanley (NYSE: MS  ) 69%
JPMorgan Chase (NYSE: JPM  ) 74%
Wells Fargo (NYSE: WFC  ) 77%

Source: Yahoo! Finance.

But according to Morgan Stanley, more than half of the 236 reverse splits it studied underperformed the market for several months after the split. (That said, Morgan Stanley found a small number of those stocks had significantly outperformed the market six months after the reverse split. That's consistent with the theory about expanding the pool of potential investors.)

Looking longer term, conclusions from an exhaustive 2008 study of 1,612 reverse splits that occurred between 1962 and 2001 were emphatically negative. The study stated, "These stocks record statistically significant negative abnormal returns over the three-year period following the month of the reverse split." In plain English, odds are a reverse split is a good sell signal for a three-year horizon.

That’s because reverse splits occur when the company is financially distressed, and financial performance tends to stink for years. 

The study went on to warn that "the market underestimates the future poor performances of reverse stock splits." But shorting these stocks is risky. The study favored the idea in theory but concluded reverse-split stocks have characteristics that make them particularly difficult to short. 

Foolish takeaway
There's a lot I don't like about Citigroup, including the quality of its management, earnings, and balance sheet. The reverse split looks like one more sell signal for this TARP poster bank.

But there are two sides to every trade … who's buying the stock and why?

If you would like more help figuring out if Citigroup's reverse split is a sell signal, you can use the Motley Fool’s new Watchlist feature to get up-to-date news and analysis. Click below to add companies to your Watchlist now:

The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Through a separate Rising Stars portfolio, The Fool is also short Bank of America. Fool contributor Cindy Johnson has been underweight financials since 2008, which has been a good move overall (albeit not without its rough patches). She does not own shares in any security in this story. No way. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 09, 2011, at 2:34 PM, mikecoursey wrote:

    I'm not a big fan of your headline even though I understand what you are driving at when I read your article. That being said, I'm also not a big fan of Citigroup for a variety of reasons. I can understand the overall strategic advantage of Citigroup in performing the reverse stock split. By giving it access back to the various funds it has a better chance of getting the stock price and overall valuation of the company back where it wants to be.

    However, the true valuation of this company is still well below market value even at that. Citigroup needs to work more on their balance sheet and less on their overall PR. When a company has a strong balance sheet and provides better value to its customers rather than yahoo style finanacing then you will see better overall performance across the board.

  • Report this Comment On May 09, 2011, at 4:10 PM, BabaRamDass wrote:

    "For example" is not proof. Whatever the reasons for and history of specific reverse splits, Citi's reverse split has no more bearing on its future success than a 10 for 1 split would have. The company is the same as it was before the split, with exactly the same issues and opportunities.

    If you want to look at a company that was tremendously successful after its 1 for 10 reverse split, try Laboratory Corporation of America. LH artificially went from about $3 per share to about $30 per share after its reverse split. Since then it split 2 for 1, and last time I looked, it was running at about $90/share. You do the math.

    LH was a good company in the making--with or without the reverse split. Citi's reverse split says zero about whether it is or is not a good bank in the remaking.

  • Report this Comment On May 09, 2011, at 4:19 PM, wasmick wrote:

    "There's a lot I don't like about Citigroup, including the quality of its management, earnings, and balance sheet. The reverse split looks like one more sell signal for this TARP poster bank."

    If your article attempted top delve into these three metrics, this article might have actually led to an interesting and informative discussion about the stock.

    Unfortunately, it didn't so instead we get more simplistic, lowest common denominator pablum...some of it years out of date.

    Please do some research before writing. Believe it or not there are some poor folks on this site who actually believe what they read here.

  • Report this Comment On May 09, 2011, at 6:42 PM, HectorLemans wrote:

    Calm down arm-chair Buffets. I thought it was a good succinct, enlightening article. It at least got me thinking. Hopefully there'll be some more Citigroup articles that explore other issues. Correlation doesn't imply causation when it comes to reverse splits, but the statistics indicates they're at least indirectly related.

    Oh, and BabaRamDass - as Yoda might say..."One data point does not a trend make"

  • Report this Comment On May 09, 2011, at 6:55 PM, dogofthefuture wrote:

    I had two shares on my scorecard @ 4.11 up 10% 5/6. Today I'm up 975%!?? Please explain.

  • Report this Comment On May 09, 2011, at 7:05 PM, xetn wrote:

    I believe all the major banks are sitting on a time bomb that is about to explode in the next couple of years (the huge inventory of real estate defaults). So far, they have managed to keep a "lid on" by not proceeding with foreclosure. They also have a legal problem they are all trying to solve with the electronic title transfers. And, each day the "value" of these properties keeps dropping. This means their collateral is declining, such that they are way over loaned on many of these properties. That, to me, means their balance sheets are way over stated. And, at some point in the near future, the "chickens will come home to roost".

    I wouldn't touch any of them with a ten foot foolish pole.

  • Report this Comment On May 09, 2011, at 7:27 PM, blessedbyhim wrote:

    I would appreciate a link to the research you quoted from in your article. Specifically, I'd like to see the information about how the reverse splits usually result in lower share prices. I think we all know this to be true from experience, (eg., companies use it to try to avoid de-listing) but I prefer to be able to look at the data that a contributor is sourcing for their article. Thanks!

  • Report this Comment On May 09, 2011, at 7:47 PM, twitbustr wrote:

    Wasmick from above is too kind with calling you out. Pablum is not the word I would use to describe your tripe. Innuendo and half-facts are the hallmarks of cowardly, self-serving, B & P for journalism; this and your other hit piece on financials and C in particular, are poster children for such trash. Never let facts get in your way missy.

  • Report this Comment On May 09, 2011, at 9:33 PM, dbtheonly wrote:

    Dog,

    Your scorecard did not adjust for the reverse split. It saw $4 one day & $40 the next & did what computers do.

    Twit,

    Own C do we?

  • Report this Comment On May 10, 2011, at 2:59 PM, wasmick wrote:

    @Hector Lemans,

    "I thought it was a good succinct, enlightening article. It at least got me thinking."

    Really? Really and truly!?!

    I am very, very sorry to hear that.

  • Report this Comment On May 10, 2011, at 3:14 PM, mikecart1 wrote:

    When Citigroup hits $60/share, will this article suddenly disappear?

  • Report this Comment On May 10, 2011, at 10:14 PM, thepainter32 wrote:

    You really think C will hit $60? How old will we be when this happens?

  • Report this Comment On May 11, 2011, at 5:56 PM, BabaRamDass wrote:

    "Oh, and BabaRamDass - as Yoda might say...'One data point does not a trend make'"

    Hector--with respect, you missed my point--or confirmed it. I wasn't suggesting that the LH story equals a trend. I was just suggesting that not all reverse splits are doomed to failure, and LH--coincidentally or by design--was a spectacularly successful reverse split.

    I suspect the correlation you refer to is much stronger between reverse-split companies who are on the verge of being delisted and stock price downdrafts after the reverse split. LH was not in danger of being delisted. Neither was Citi.

    Best.

    BRD

  • Report this Comment On May 13, 2011, at 1:41 PM, nowshade wrote:

    The fact that Citi went down substantially after the split makes this article justifiable to some extent. Albeit, the premises used are quite fallacious.

    You might want to read these articles:

    http://www.bloomberg.com/news/2011-05-09/ocbc-world-s-strong...

    http://blogs.wsj.com/deals/2011/05/13/citis-vikram-pandit-th...

  • Report this Comment On May 13, 2011, at 2:07 PM, Truth2Power wrote:

    Took a small position in C at $3.76. Wasn't really a fan of the fundamentals then, but thought the stock's low valuation was still a little too low. Things were just dandy and the stock was up to $4.50 pre-split. Now we're back to an adjusted $4.10. Not sure what to make of this.

  • Report this Comment On May 15, 2011, at 11:59 PM, tomd728 wrote:

    Cindy.........

    Nice work !!!!!!!! Don't like Management, Balance Sheet, Earnings ? Me either. Citi is a dog with fleas

    that will only get mange at 30 +.

    What the hell does Dick Parsons ever bring to the party ?

    Thanks,

    Tom Durkin

  • Report this Comment On July 07, 2011, at 9:52 PM, billypae wrote:

    I agree with the article. Let's follow China. As interest rates rise to 7.00 let the banks make their money and we'll all get better. Maybe more lending will help the economy, but maybe we as consumers need to start paying back out personal debts! It's not that the American government is broke, in some ways, we the people of America are broke and the government is too. Let's get responsible and raise the interest rates. We need to pay our debts back. It is too comfortable from the consumer viewpoint with interest rates this low, so let's discourage borrowing and further debt making. Let's give the banks their interest rates and profit so they can start paying off their debts! Doesn't raising our interest rates heal our economy? I realize that this is a contrarian perspective, but equally valid! If and when interest rates rise, and they are slowly around the world like in Brazil (11%) and India (6.5%), then we'll get better. Greece at 30% is too high for their government from a practical standpoint to pay back, but if the US goes to 7% we'd all be better off and Citigroup would be the great investment it is lining itself up to be. It was $1.35 in 2009, now it is $41.00. You can't say that it is not improving because it is. I thought the 1:10 reverse split would negate the potential in share earning of about 10X when one looks at the normal stock prices prior to the WAshington Mutual Bank collapse that sent a trillion dollar hole ripping through the economy. When one looks at the normal stock prices before the March 2009 impact of the Wamu bankruptcy in September 2008, for the past 5 years it was reported to be at $50, but even after the 1:10 reverse split, potential stock share prices now are reported to have been $500. So, the 1:10 reverse split did not negate the potential 10X return on investment in Citigroup shares! That is important! The 1:10 reverse split did not take away the possibility of a 10 fold return on Citigroup assuming it goes from its $42 dollars a share to $500 when it recovers from this global and ubiquitous financial debt crisis. If interest rates rise, banks would recover exponentially in time, and the economy would recover. If Bernanke does the unthinkable, he'd be an economic hero!

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