Unless you spend your time reading books and magazines on investing and watching and listening to financial news (and maybe even if you do), you don’t hear too much about spin-offs. People love to talk about mergers and acquisitions - CEOs love to hear themselves say the word “synergy” and talk about the cost savings and opportunities presented by the merger. Mergers are exciting. For a company’s management, I would suspect it’s sort of an ego thing – “we’re all so good at running our company that after we paid all the salaries, invested in R&D, and paid down our immediate liabilities, we still had enough capital left over to buy, well, your entire company.” You don’t hear anyone bragging about how they spun off a division of their company and made two smaller companies, with separate management structures. Even if you don’t hear about it often, you should take notice of it when you do.
Why? Because investing in spin-offs can be ridiculously profitable. Studies have shown that stocks of spinoff companies outperformed other companies in the same industry and the S&P 500 index by about 10% per year in their first 3 years of independence. It’s now common knowledge that spin-offs can provide excellent opportunities for producing outsized returns.
Of course, you might be thinking to yourself, “that’s not how markets work – once everyone knows something achieves better than average returns, it ceases to do so, because the prices get bid up to the point that the extra returns no longer exist.” Not so, according to Joel Greenblatt, author of two books, The Little Book that Beats the Market and You Can be a Stock Market Genius and founder of Gotham Capital and The Value Investors Club.
The reason the market doesn’t bid these shares up to the point of perfect efficiency, is because most of the money in markets is held by large institutions. These institutions are subject to very specific rules and guidelines. For instance, most institutional investors are only allowed to own large cap stocks, many are limited to the S&P 500. Spin-offs will typically be spun from a large, S&P-type company, owned by institutions, leaving the institutions with a stock they aren’t allowed to own. So they sell it. And all their big, institutional investor friends sell it. They all sell it indiscriminately, that is, with no regard for the price. So even if its not properly being valued by the market, they sell it anyway, because that’s the nature of the beast. These guys hardly have time to follow the stocks they can invest in, they don’t care about the ones they can’t.
Of course, you’ll have to consider the reason for the spin-off. Sometimes it’s because a company is being underappreciated by the market. Obviously, this is a great spin-off to be invested in. In other situations, though, they may be spinning-off all kinds of bad debt and risky assets along with the new company. So, if you’re going to buy these, its prudent to review the SEC filings that go along with a spin-off, so you can understand exactly what’s going on. Of course, the numbers that demonstrate the market beating returns are across all spin-offs, so if you just bought every spin-off, you could probably do a lot worse.
How do you find spin-offs? It’s easy. Read the Wall Street Journal or do a Google search and then sort for “news.” Or better yet, I’ll just tell you some of the relevant ones in the news right now. Here are some I found in the most recent BusinessWeek: (1) Time Warner is spinning off its AOL division, (2) Potlatch recently spun-off Clearwater Paper (no debt according to BusinessWeek), and (3) Hutchison Telecommunications International spun off its Hong Kong and Macau operations as Hutchison Telecommunications Hong Kong Holdings (trading at around book value according to BusinessWeek). Not convinced, do some digging. Look up the studies yourself. Read Greenblatt and Seth Klarman. Let those guys convince you. They know a lot more than I do. Good luck. Remember to donate half your profits to this site;) Thanks for reading.
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