Reverse Splits: Fewer Pieces of a Smaller Pie

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Index More Important than Price

The notion that major institutions must sell a stock if it goes below $10, $5, or even $1 seems to be an urban myth. The largest mutual fund companies, including T. Rowe Price (TROW), say no such rules exist for their funds. At Vanguard Group, "we'll own the stock as long as it remains in [an index] fund's target benchmark," says spokesman John Woerth. And there is no single threshold among the company's actively managed portfolios, he says.

The Council of Institutional Investors is unaware of rules requiring institutional investors to sell equities when they dip below a certain price. Indeed, that's the case at major pension funds, such as California State Teachers' Retirement System (CalSTRS). "CalSTRS has no rule to sell below a certain amount," according to a spokeswoman.

So that leaves the psychological barrier of a sub-$5 share price, which is a huge one from a confidence perspective, says Anton Schutz, manager of the Burnham Financial Services Fund (BURKX). "People look at low stock prices, and think 'Wow, this company must be in trouble,'" Schutz says. That's why some of the megabanks, including Citigroup, (C) may try to engineer a reverse stock split in the coming months, he predicts. A reverse stock split is "financially meaningless, but the optics are better," Schutz adds.

Tough to Sell Short

While reverse stock splits don't have a stellar track record, shorting companies who complete a reverse stock split is often futile. The short interest in these stocks is "essentially zero" two-thirds of the time in three-year period following the split because broker-dealers don't have them in their inventory. "You can't borrow them to sell them short," Goizueta's Rosenfeld says. "Even if you expect [the stock price to go down], you really can't profit from it."

Young is a Personal Business editor for BusinessWeek .