Long term stock returns following reverse stock splits

The objective of this paper is to investigate the performance of stock returns after reverse splits over three year intervals. The sample consists of all reverse splits in CRSP tapes and is available on the Compustat annual tapes during the period 1981- 2010:3. This paper employs the effective date to trace the stock returns after the split. The following issues can be addressed. First, is there a significant difference in stock returns after reverse-splits between the small capital stocks and large capital stocks? Second, if the reverse-splits firms have continuous negative returns over long-run period, how does this affect the wealth of long-term shareholders? Third, does reverse split increase the liquidity of the stock?  Fourth, how do institutional investors act around the reverse splits? The reason is that institutional investors may avoid low-prices stocks for practical reasons such as high transaction costs. However, reverse splits make these firms more attractive to institutional investors because increasing the share price reduce the transaction costs and help investors to buy the stocks on margin.

Our sample consists of reverse stock splits that have effective dates on the University of Chicago’s Center for Research in Security Prices (CRSP) and available on the Compustat during the period 1981-2010:3. If firms reverse splits their stocks but liquidate or are taken private just a few months afterward, then they will not be included. Following the Kim, Klein, and Rosenfeld (2008), this paper does not include splits factors less than 1:2 because small reverse splits result in negligible stock market reactions. These criteria results in a sample of 1930 firms. Sample firms are listed on the NYSE, AMEX, and NASDAQ exchanges.

The long-term behavior of the abnormal returns is quite different from the previous studies. The abnormal returns on the effective month are negative and highly significant. The cumulative abnormal returns from month +1 to month +36 are positive and highly significant for small firms. The only exception is the large firms that the cumulative abnormal returns are negative and significant at 10% level over the period of +1 to +12 month. The additional difference between small and large firms is that the cumulative abnormal returns of the ex-splits are negative for small firms, but positive for large firms. The result of this paper shows that the trading volume significantly increases after reverse stock splits.