Citigroup's Reverse Split Could Be Toxic For Investors

BOSTON (TheStreet) — Citigroup’s(C) plan for a reverse split was greeted with a chorus of boos, as investors frowned upon the bailed-out bank’s use of a cosmetic change to artificially boost its stagnant share price from $4 to $40. Retail investors at home should jeer Citigroup’s decision, too, but for different reasons.

In March, Citigroup announced plans for a 10-for-1 reverse stock split, which will propel the share price to above $40 by reducing the number of outstanding shares from 29 billion to less than 3 billion. Set to take effect May 6, Citigroup CEO Vikram Pandit contends that the reverse split, coupled with the reinstatement of a penny-per-share dividend “are important steps as we anticipate returning capital to shareholders starting next year.”

On Monday, Citigroup reported a first-quarter profit of 10 cents a share, coming in a penny ahead of the average analyst estimate. However, Citigroup’s $3 billion in net income was padded by a $3.3 billion reserve release in the quarter. Revenue of $19.7 billion also fell short of Wall Street’s expectations.

Reverse splits are generally pooh-poohed by professional investors because nothing fundamentally changes with a company, even if retail investors believe the higher share price denotes an increase in quality. The only change is the number of shares outstanding and the price of each share, but value and earnings are not affected by the decision.

The one positive argument to be made for the reverse split is that many mutual funds have charters that restrict portfolio managers from buying stocks that trade below $5. The argument is that, post-split, Citigroup becomes an investment candidate for many institutional buyers previously forbidden from owning the bank stock.

However, there are many reasons a reverse split is bad, and not just in Citigroup’s case. Aside from appearing to be a move made out of desperation, stocks typically fail to perform well after a reverse split is enacted. According to a 2006 joint study conducted by students at NYU’s Stern Business School and Emory’s Goizueta Business School, more than 1,600 companies that conducted reverse splits underperformed the broader market by about 50%, on average, in the three years after the split.

Recently, though, companies have shown an ability to thrive with or without a reverse split. Both Priceline.com(PCLN) and troubled insurer American International Group(AIG) have rallied after their respective reverse splits.

Meanwhile, Sirius XM(SIRI), for which shareholders approved a reverse split after the satellite-radio company flirted with bankruptcy and possible delisting, has seen its stock price roar back by 1,000%. In Sirius XM’s most recent shareholder proxy, a call for a reverse split was notably absent, leading investors to believe it is officially off the table now.

 

For Citigroup investors, the major negative of a reverse split in particular comes due to the stock’s popularity among the high-frequency trading, or HFT, crowd. As a well-known institution, Citigroup becomes very attractive to high-frequency traders due to the low share price, massive amount of shares outstanding, and the penny increment on which the stock must trade.

Retail brokers are forced to buy Citigroup shares rounded to the nearest penny. For HFTs, a penny spread on a $4 stock is a boon as they aren’t required to put up much capital. That will change when the stock trades for $40 post-split, says Jamie Selway, managing director at Investment Technology Group and a board member at exchange operator BATS Global Markets.

“The spread will still be a penny, which will aggravate HFT because they love putting up $4 for the penny spread,” Selway says. “Now they have to put up $40 to make a penny spread. From a bang-for-your-buck perspective, it got 10 times worse.”

HFT gets a bad rap following the so-called Flash Crash one year ago, when computer programs were blamed for the near-instantaneous plummet in share prices. However, Selway says that characterization isn’t fair, especially in Citigroup’s case, as HFT plays a critical role as liquidity provider.

“Whether it’s HFT or a market maker, there are always counterparties,” Selway says. “There are always going to be liquidity providers in the market place. Retail client aunt Millie isn’t going to match with uncle Bob. Two retail traders coming together is not the way markets work. You have instances where liquidity providers step in and provides the grease to keep the wheels going.”

Keith Bliss, senior vice president at brokerage Cuttone & Company, offers another advantage high-frequency traders will miss out on: rebates. Due to the low price and massive daily volume, Citigroup has been perhaps the most popular pick because of a rebate paid by trading centres to traders for directing the flow of orders to exchanges. Moving millions of shares of a low-priced stock has enabled traders to reap the rebate reward, although the party will end with the reverse split.

 

“High-frequency traders weren’t trading in and out for investment purposes. They were posting orders to get the liquidity rebate,” Bliss says. “You’re going to see a lot less volume in the stock, without question.”

Bliss notes the irony in how HFT actually tends to have a calming effect on the volatility of highly trafficked stocks like Citigroup. With a lesser amount of HFT occurring in Citigroup post-split, Bliss wonders if there will be more dramatic swings in the share price after May 6.

“There are always bids and offers around price it’s trading, no matter if good or bad news comes out,” he says. “If seven-figure orders from institutions came in, the HFT had a dampening effect on that order. It would get lost in the mix when 700 million shares trade in a day. We don’t know for sure, but that will likely go away after the reverse split.”

This post originally appeared at TheStreet.

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