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A spinoff that's cutting costs and riding a demographic wave

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April 15, 2014 – Comments (6) | RELATED TICKERS: KN , DOV , CSD

Anyone who looks at my portfolio of stocks here in CAPS will see that I invest almost exclusively in special situations.  I plan on talking about riding the coattails of activist investors and investing in demutualizations in the future because I've found some amazing statistics on the outperformance of those types of investments.  Today I want to talk about investing in spinoffs.

A fairly recent study by Credit Suisse concluded that over the past seventeen years spinoffs have beaten the S&P 500 index by 13% during their first year as public companies.  Another recent study found that the stock of spun off companies outperforms their former parents by 20% over the next three years, with the bulk of that outperformance coming during the first twelve months.

For more evidence, take a look at the Guggenheim Spin-Off ETF (CSD). I have a decent amount of the cash that I would have put in say and S&P 500 index fund allocated to CSD. It has done quite well, substantially better than an equivalent major index. For a point of reference, Since I went long CSD in CAPS in June 2010 it has outperformed the S&P 500 +128.42% to +69.25%. That's nearly 60% worth of outperformance, or around 15% per year, which is substantial.

Something that I have been thinking about though...is this delta in performance alpha or beta? By this I mean we have essentially been in a major bull market ever since I started following and purchasing CSD. Is its excess returns just a magnification of the market's overall activity, or is it truly outperforming because it invests in better companies? I think that it's the latter, but we really won't know for certain until we see a longer bear market.

Anyhow, there's very compelling evidence that spinoffs outperform the market out there.  The specific spinoff that I want to talk about in this post is a company that was recently spunoff of Dover Corporation (DOV), Knowles Corporation (KN).

In short, Kowles manufacturers all things related to speakers and microphones, from components of smartphones to hearing aids.  A couple of things really stood out for me after going over the roadshow presentation for the spinoff a couple of months ago.

-  First of all, as I mentioned Knowles is a spinoff which I love.

- Second Knowles has a solid track record of growth that I think should continue, though perhaps at a slightly slower pace, at what seemed to me a reasonable valuation.

- While the hearing aid sector is small it certainly has demographic tailwinds.  Smartphones are a pretty good sector to be in as well.

- In its presentation Knowles management talked about how they were planning to cut costs by consolidating their manufacturing facilities.

New information that I was able to glean from a recent Barron's article that I like:

- KN trades at a discount to its peers on a forward earnings basis (I know that it's dangerous to look at forward earnings) at 12x when the others average 15x.

- The potential for additional microphones to be added to smartphones as they go higher end.

- The author of the Barron's piece believes that Knowles will have ample cash flow to initiate buybacks or possibly start paying a dividend in the near future.

When all is said and done I think that Knowles is a solid addition to the basket of spinoffs that I am building.

I'd love to hear others thoughts on KN or any other investments that they've found interesting lately, particularly those of the special situation variety.

Jason

6 Comments – Post Your Own

#1) On April 15, 2014 at 5:29 PM, Mega (99.95) wrote:

"Something that I have been thinking about though...is this delta in performance alpha or beta? By this I mean we have essentially been in a major bull market ever since I started following and purchasing CSD. Is its excess returns just a magnification of the market's overall activity, or is it truly outperforming because it invests in better companies?"

Good question. 15% outperformance over 4 years looks pretty comparable to 13% over 17 years. Maybe just a bit of beta mixed in.

Do you think the return primarily comes from spinoffs being better companies or from being cheaper?

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#2) On April 15, 2014 at 6:33 PM, Lordrobot (92.49) wrote:

Don't want to be Mr. Bringdown here but Kn is a commodity maker just like Apple. Innovation or not, there are two sure fire expectations: There will be competition from Asia and margins will shrink over time. In this instance I am referenceing Apple's hardware not their software or apps.

All spin off's are not equal. Years ago Union Carbide spun off PX. The businss model here was stand alone industrial gases. More recently we are seeing junk spinoff's such as low margin businesses or as in the case of Nobel NE, the spin off of its old drilling rigs.

I would look to the business and the model. Does the business have control over its prices or does it have a commodity dictating prices. What does the cost of entry look like. Who is the competition. If it is consumer electronics then its Asia and sorry, that's not who I want to compete with. But I liked your special situation thinking. I deploy that in my real life investing but I have concerns about any consumer electronic's producer goign toe to toe with Asia. 

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#3) On April 15, 2014 at 9:25 PM, TMFDeej (99.43) wrote:

Thanks for the comment Mega. I don't think that the spun off companies are better businesses than their former parents. Some are better and some are worse. Backing the day spinoffs were often indiscriminately sold off by many investors creating great entry points. That doesn't seem to be happening now either. 

I think that he majority of the outperformance likely ones from multiple expansion created by investors who can buy a more focused company or to put it anther way, the elimination of the conglomerate discount. Increased operational focus by a management that is not only freed from being watched over by the former parent but often has compensation that is directly tied to the new entity's performance may contribute as well.  The potential for the spun off company to eventually be acquired by someone else is also there. 

Jason 

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#4) On April 15, 2014 at 9:43 PM, TMFDeej (99.43) wrote:

No worries Mr. Robot. Bear arguments are more than welcome, particularly polite ones :). Many comanes have indeed been spinning off crummy, low margin businesses. I don't think that's the case here though. 

You make a very good point about the KN's heavy closure to consumer electronics.  So far its margins have been very stable in the mobile consumer electronics segment, 30% in 2011, 28% in 2012 and 32% in 2013. So there certainly does not appear to be any margin deterioration as a result if low cost competition, yet. Management claims that the production of systems rather than individual components, innovation, patents, proprietary efficient manufacturing techniques and relationships give it an edge over the competition.  We'll see.  

 I like the opportunity here, but I certainly understand your concerns. That's one of te reason that I will never run as concentrated a portfolio as some investors. I like to put together a bunch of special situations an watch them play out over time. I may not double my entire portfilio with one single good idea, but I won't get hammered by a bad one either. 

 Here's a link to the KN presentation for anyone who's interested:

 http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MjIxMDQ4fENoaWxkSUQ9LTF8VHlwZT0z&t=1

Jason 

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#5) On April 16, 2014 at 1:26 PM, EnigmaDude (93.40) wrote:

Good post and good comments. Wish you would blog more. Has it really been a year since the last time you found a special situation that interested you, or have you just been busy doing other things?

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#6) On April 16, 2014 at 4:28 PM, TMFDeej (99.43) wrote:

Thanks for the kind words Enigma.  There's a lot of special situations that I find interesting.  I just haven't really had as much time to write about them.  I'm slowly getting back into writing though.

See you around.

Jason

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