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Why These Splits Should Scare You

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Stock splits have long been a controversial topic among investment analysts. Despite having no real impact on a company, investors perceive splits as more than just a cosmetic change in the number of shares outstanding and current price of those shares.

From a regular stock split, investors often infer the prospect for substantial future growth. But with reverse splits, the opposite feeling of pessimism can be much stronger -- and with exchange-traded funds that do reverse splits, those feelings are justified.

Recently, the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX  ) announced it would do a 1-for-4 reverse split next week. As the second such reverse split in less than two years, the obvious question for investors is what the repeated need for such action makes this and similar exchange-traded products a bad investment. I'll take a stab at answering that question below, but first, let's look at splits a bit more closely.

Reverse splits and you
Stock splits used to make a lot more sense than they do now. In the past, full-service brokers preferred to trade in round lots of 100 shares, and so once a stock's price got too high, it got difficult for ordinary investors to afford a full 100-share lot. Splits helped bring prices back into line. With discount brokers making it easy to buy smaller numbers of shares, the need for stock splits largely went away.

But reverse splits still serve a vital purpose. When a stock's price gets too small, a company risks getting its shares delisted from the exchanges on which it trades. Sirius XM (Nasdaq: SIRI  ) , for instance, almost required a reverse split to get its stock price above the key $1-per-share mark before finally eclipsing the level without assistance. Moreover, a reverse split doesn't have to be a death knell, as the experience of (Nasdaq: PCLN  ) and its 1-for-6 reverse split during the tech bust shows.

Because a reverse split is only needed when prices fall dramatically, it's often a bad sign when they happen. And although not all reverse splits are fatal, you'll find in the ETF world that they often bode ill in the long run.

ETFs doing the splits
The Barclays VIX ETN isn't the only exchange-traded product to do multiple reverse splits. During the plunge in natural gas prices, theUnited States Natural Gas ETF (NYSE: UNG  ) did two reverse splits within less than a year, eventually leaving investors with just one new share for every eight shares they owned prior to the splits. The combination of falling prices and the impact of contango in the futures markets led to the need for the ETF to split.

ProShares actually had multiple splits going in both directions earlier this year. The fund company announced six ETFs with regular splits and 11 with reverse splits, ranging from a 3-for-1 standard split for its bullish ETF on the Dow to a 1-for-5 reverse split on several of its leveraged short funds.

On the other hand, not all exchange-traded products get around to doing reverse splits even when arguably they should. The VelocityShares Daily 2x VIX Short-Term ETN (NYSE: TVIX  ) adds leverage to the volatility picture, and the ETN has lost almost 99% of its value in less than two years, closing yesterday at just $1.39. Despite the drop, the company hasn't announced any plans to do a reverse split to get its share price up.

Don't go in reverse
The need for reverse splits is almost always a sign of a serious problem in an investment, whether it's stock in a regular company or shares of an ETF or other fund. Whenever you see a reverse split about to take place, you should get the message loud and clear that there's a good possibility that the ETF isn't suitable as a long-term investment.

With stocks, though, the threat of a reverse split can inspire a company to greatness. Find out how that worked with the big player in satellite radio in the Fool's special report on Sirius XM. Your opportunity to get in the know is just a click away.

Fool contributor Dan Caplinger never could do a split. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Priceline. Motley Fool newsletter services have recommended buying shares of Priceline. 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 Fool's disclosure policy loves a good banana split.

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  • Report this Comment On September 25, 2012, at 6:48 PM, dsandman999 wrote:

    There are a couple of other reasons for doing reverse splits.

    1) Reduce the number of shareholdrs. A 1 for 10 eliminates all the 9 or fewer holders. These are usually left overs from drips or such that arrive after the sell and are not worth the broker cost to sell. Yet they cost the company time and money to service, count, and notify. Less so in the electronic age, but lots of paper still gets printed and mailed. Some protest groups were also noted for buying a single share.

    2) The above is also true for Dividend stocks or soon to be ones. The company now has to service all these share owners on a quarterly or monthly basis, not just once a year. Savings can be very substantial when multipled by 4 or 12.

    3) In the dividend case, it also makes sense to increase the size of the dividend paid out to whole pennies especially if someone with 100 shares would get less than a penny. That was what Citicorp (C) did with their reverse split in prep for resuming dividends and to get their stock above the magic $5 so that some institutions and funds would not automatically reject the stock because of its price.

    4) A turn around story like Siri might do a reverse split to get its counts more inline with others of its size. This makes comparing fully diluted regular EPS closer to expectations, as opposed to diluted being 2x a non-diluted EPS. A 1 for 5 would get the share count down for ~7B fully diluted to ~1.4B and put the price over the magic $5 at around $12.50. This can reduce the volitility introduced by day traders and high frequency trading.

    I would make the distinction in your article between those cases where the reverse is spiraling down with the company vs. a case of clean up and preperation to handle a success story.

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