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Monday, May 9, 2011

Citigroup: the 1-for-10 reverse split



Some Citigroup shareholders woke up this morning to a surprise; they found that the price of their stock had jumped from around $4.50 to $44.00!

Unfortunately, today’s price jump was not an overnight stock rush, but merely a 1-for-10 reverse split. That is, if you owned 10 shares of Citigroup on Friday with earnings of $0.31 per share, you now own 1 share of Citigroup with $3.10 of earnings per share. In other words, aside from the price, there is no material change in your ownership. Why would Citigroup do this?

CNBC suggested on its website that the reverse split was done to “improve investor’s opinion” of the stock. Other blogs have suggested that doing a 1-for-10 reverse split is a way to “trick” or “fool” investors into thinking they are buying a better company.

Pardon me for saying, but if you think that a $40 stock is “better” than a $4 stock, or a $100 per share company is “better” than a $50 per share company, you need to stop buying stocks until you know what you are doing.

In fact, there are several good reasons for doing a 1-for-10 split, none of which are listed above.

The first reason is to counter day trading. When a stock has a low price but trades with high volume (like Citigroup), it becomes a favorite with day traders. For a low priced stock, a change of a few cents means a few percentage points, and so such trades can be profitable for a day trader. Unfortunately, day traders do not add value to a company the way that long-term shareholders do. Increasing the share price helps keep day traders out and, according to Citi CEO Vikram Pandit, therefore reduces volatility. In the very short-term, the exit of day traders will likely cause a drop in Citi’s stock price.

The second reason is to bring in potential institutional buyers, such as mutual funds. Many mutual funds are not allowed to purchase a stock that is priced below a certain threshold, usually $5 or $10. At $4.50, many mutual funds are simply not allowed to buy shares, no matter how good the company might be as an investment. Although a 1-for-10 reverse split doesn’t really change anything except the price, more mutual fund managers will now be able to buy Citi shares.

The third reason is to allow pension funds to buy the shares. Just as many mutual funds are not allowed to buy stock worth less than $5 per share, many pension funds are not allowed to buy a stock that does not pay a dividend. With 29 billion shares outstanding previously, Citigroup would have found it difficult to pay even a token $0.01 dividend per share. As of today, there are 1/10th as many shares, and so Citigroup can once again introduce a dividend. Once this dividend is in place, more pension funds will be allowed to buy.

Aside from growing revenue and earnings, part of any good company’s strategy is to manage their stock. Institutional investors and pension funds add stability, since they tend to hold for weeks or months rather than just hours. And, if many institutional investors buy and hold, this limits the availability of the stock, driving up prices.

Today’s 10-for-1 reverse split was an immaterial - yet smart - long-term move for Citigroup.

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"You never want to think the best things are in the past. You want to get yourself to believe that the best things are going to be in the future."

Sandy Weill, former CEO of Citigroup


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