Spinoffs — An Easy Stock Investing Strategy for Individual Investors
Joel Greenblatt is one of the most successful hedge fund managers and investors of the last 30 years. In one of Mr. Greenblatt’s books he outlines a relatively simple strategy for small individual investors that can help them achieve above market returns — investing in spinoffs.
Stock spinoffs statistically beat market returns and carefully picking your spots can further increase your returns. Investing in spinoffs is also a strategy that is easy to follow for individual and beginner investors, often with clearly visible results within 6–12 month periods. This article outlines where you can find out about and research upcoming spinoffs and the drivers of spinoff outperformance. The investor should look out for these characteristics when evaluating whether to invest in a spunoff stock, or in the parent.
Upcoming spinoffs can be found here and recent spinoffs can be found here. Thereafter, you can find more detail on the parent company, company being spunoff, and reason for spinoff by reviewing the 10–12B document filed by the parent company here. Even if you don’t have access to S&P’s Capital IQ tool or Bloomberg, it is still possible and easy to track the stock, once listed, on Yahoo finance and compare its valuation multiples (particularly EV/EBITDA, EV/EBIT, and P/E) to other similar companies (similar by industry, product type and size) and industry averages.
A very basic preliminary analysis could look something like this:
Reasons for a company being spunoff include, management or an activist investor trying to unlock value, facilitating a merger, regulatory, improving cash-flow position, or specializing operations.
Several factors drive spinoff outperformance. First, a diversification discount disappears once the company is a standalone company. Second, as a standalone company it is simpler for management to align incentives. Third, spinoffs are more likely to be acquired than larger parents (conglomerates). Lastly, there is often an initial selloff of spinoff stocks by large institutional investors (pension funds etc.).
A “diversification discount” means that a stock is undervalued because investors find it difficult to value different business lines correctly. It is easier for an investor to value a standalone company than a conglomerate and therefore it is more likely for the spinoff’s price to correct; if it was undervalued then the price is more likely to rise once spunoff. Generally, the more different a spunoff division is to its parent the more opportunity there is for a correction of valuation and positive investment returns. Investors often discount the forced diversification of a conglomerate (or even more simple holding company-subsidiaries structure) because:
· It is more difficult for investors to classify each subsidiary.
· Different subsidiaries may require different valuation metrics.
· Information asymmetry — it is more difficult for investors to identify the revenue, costs, and profitability of each subsidiary in order to use the correct valuation approach.
· Investors value choice and conglomerates attract less specific investors than standalone companies.
· It is more difficult to identify fast growth divisions when they are part of a conglomerate and therefore it is less likely that a higher growth multiple is applied to those divisions
· A standalone company could eventually attract more analyst coverage and allow for higher quality coverage
The second major reason for spinoffs to outperform as standalone companies is that it is simpler for management to align incentives.
· The standalone company can optimize its capital structure and leverage
· The standalone company can determine the best allocation of its capital, without considering the interests of the parent. This is especially important if a profitable subsidiary / division was subsidizing the parent company.
· Management can focus on a single or smaller set of goals.
· As the management team of a standalone public company the management team will be better held accountable for performance and more likely to respond to market scrutiny
· The spinoff will be free of the bureaucracy of its relationship with the parent
· Smaller teams and companies can be more adaptable
· Management of the spinoff / division / subsidiary can be better incentivized and aligned based on the performance of the standalone stock (through stock options) rather than as part of the parent / conglomerate’s performance.
A third reason spinoffs generally outperform the market is that historically spinoffs are ~5x more likely than other companies to be acquired and when they are acquired there is often a premium paid. A fourth reason a nimble investor can achieve above market returns from investing in spinoffs is systemic, but does, somewhat, depend on timing. Often spinoff stocks are heavily sold off by institutional investors soon after listing (between 10 business days to 2 months after listing) and this selloff is not based on investment merits or valuation. This depresses the stock price of the spinoff, often until the stock is rediscovered as a standalone stock and the price corrects.
· Institutional investors with restrictions (company size, etf’s, sector requirements, etc.) will be forced to sell their positions in the spunoff stock.
· Investors who wanted to invest in the parent (on their own behalf or on behalf of clients) and aren’t familiar with the spunoff division will sell their positions.
· Compounding this opportunity, spinoffs are often initially listed at a relatively lower price than a comparables valuation because the spinoff’s management team is incentivized to do so. More specifically, management teams of spunoff companies are often given stock option grants as incentive to join the spinoff. Therefore, if a stock is priced lower, then the management will receive more stock option units (if $ value of compensation) or simply have a lower strike price (if absolute number of units compensation). Therefore, management is incentivized to price down the stock so that they receive more stock option units or have a lower strike price on their units. These stock option units will become more valuable when the stock appreciates.
Although above I have discussed positive reasons for spinoffs, situations which could unlock value or where a nimble investor can profit, there are also negative reasons for a spinoff that the investor should be cautious of. For example:
· A company is selling a similar division.
· The company is separating out a “bad” business so that the unfettered “good” business can prosper (sell bad, buy good).
· The parent is exiting a declining industry.
· Other reasons that could be negative
In summary, spinoffs can be opportunities to achieve above market returns. To invest successfully the investor would do well to look for previously hidden investment opportunities unlocked by the stock transaction (cheap stock, leveraged risk / reward etc.). Additionally, the investor should understand the degree of difference between the spinoff and the parent (industry, product, cash flow, scale, etc.). Moreover, institutional investors might sell-off their positions in the spinoff without considering the investment merits, thereby temporarily depressing the stock price, and providing an opportunity for nimble investors. Lastly, pay attention to whether insiders want the spinoff or to be part of the spinoff.
For more detailed discussion of this topic, check out Joel Greenblatt’s book.
If I’ve forgotten anything or made any mistakes please let me know in the comments.
Good investing!
-Alex
Sources:
• J. Greenblatt, You Can Be A Stock Market Genius
• Kutscher, E. A Spinoffs Study Applied to the Airline Industry, Massachusetts Institute of Technology, 2012
• J. McConnell and A. Ovtchinikov, Predictability of Long-Term Spinoff Returns, Purdue University
