A reverse stock split may not change a company's value, but according to Morgan Stanley analysts, buying a basket of companies that have performed this maneuver, leads to market outperformance.
A reverse stock split reduces the number of shares outstanding by a certain proportion. For example, a 1-for-10 reverse split would give each current shareholder one share for every 10 they own, reducing the number of shares outstanding by a factor of 10 and increasing the price per share by the same amount—all without changing the overall value of the company.
The primary reason a group of companies might choose such a move is to boost their share price, according to Morgan Stanley analysts, including Todd Castagno and Clinton Chang.
"With an artificially inflated share price, a company's shares can potentially: meet minimum stock exchange price requirements and avoid delisting, enhance its credibility in the eyes of investors, open itself to additional institutional investors with minimum share price requirements, and reduce the volatility and turnover of its shareholder base," they write.
In general, however, a reverse stock split can be a signal that a company is struggling with years of underperformance, the analysts note, adding that the share price increase resulting from a reverse split will also not change the underlying fundamentals or economics of the business.
Citing internal research, Morgan Stanley strategists stated that this "conventional wisdom is generally correct—troubled companies tend to remain so and underperform the market."
In the past, reverse stock splits have worked primarily for small-cap stocks, with average returns boosted by a few large, extreme reversals, such as those seen in healthcare companies like Nutex Health and Madrigal Pharmaceuticals, analysts note.
"The median return of any company that implemented a reverse stock split, regardless of market capitalization, showed minimal relative return deviation from the market," they write. The analysis found that the median company implementing a reverse stock split underperforms the market by 7.5% six months after the conversion and by 4.6% 12 months after the conversion.
But when the corporate action actually works, the stocks significantly outperform the market, the analysts say. They added that if an investor were to buy a collection of reverse stock splits, the big winners would provide the basket with outperformance.