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:


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:

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.