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Why Do Spinoffs Outperform?

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February 26, 2013 – Comments (13) | RELATED TICKERS: ADT , CBB , HBIO

A significant number of my investments over the years have been in companies that have spun-off divisions or that have activist investors trying to coerce them to do so.

Taking a look at my current holdings, the following companies are somehow related to this strategy:

ADT
CBB
COV
HBIO
ITT
MDLZ
MUR
PNR
PSX
QEP
TKR
TYC
UAN
XYL

Whew, that's a lot of companies.  Sometimes this strategy works out very well, like with Kraft and Tyco, and sometimes it doesn't do much, like with ITT and friends.  Either way, as a whole, spinoffs have continued to significantly outperform the market over the past several years, even though it's hardly a secret that they do.  So much for the efficient market theory.  How much outperformance are we talking about?  According to the Bloomberg Spin-Off index (via a blog called Falkenblog) spinoffs have delivered a 15% annualized return versus 6% for the S&P 500 since 2003.

This begs the question, why do spinoffs do so well?  The traditional explanation that newly spun-off stocks are discarded by investors in the original company because they don't want to bother holding the new smaller company thus enabling keen-eyed investors to scoop up shares at unreasonably cheap valuations does not seem valid to me.  Perhaps this used to be the case, but it's not any more.  As someone who has followed just about every spinoff over the past five years very closely I can assure you that a collapse in the share price of these newly independent companies rarely happens.  If it had, I would have scooped them up.  It just doesn't.

So what's the reason that spin-offs do so well then?  Some people believe that being freed from the shackles of a parent company that was often milking its smaller, more profitable subsidiary for cash is liberating for the new company's employees, who in turn work harder and are more innovative.  I suppose that's possible.

Another traditional explanation for this outperformance is that management compensation (in the form of bonuses or shares that align their interests with shareholders) is often closely aligned with the new organization's stock price after spin-offs.  In turn, the spinoff's management will do anything that it can to drive the new company's share price higher and line their own pockets with more money.  At least has been the case in the past with some of the more successful spinoffs according to Joel Greenblatt in his investing classic You Can Be a Stock Market Genius.  I see this as very possible.

Yet another explanation that I have seen is closely tied to the newly independent companies being freed from their vampire former parents explanation that I mentioned earlier.  These new companies are now free to invest all of their free cash into their core business, improving results. 

Acquisitions play a part in the outperformance as well.  Spunoff companies can use their own stock to fund acquisitions.  Conversely, spinoffs create new, smaller companies that often ultimately make attractive acquisition targets several years down the road...or sooner as was the case with the recent Motorolla split.  Motorolla Mobility was acquired by Google less than a year after it separated from the Motorola Solutions business.

The final reason that spinoffs tend to outperform that I can think of is multiple expansion.  In theory fast-growing divisions of big lumbering companies will be afforded a higher multiple by Mr. Market than when they were obscured by a stodgy old business.  Similarly, companies that are comprised of several, fairly unrelated businesses can boost the multiples of their divisions by splitting them up, enabling investors to pick and choose which ones they want to own.  This seems to have been the theory behind the recent breakups of Kraft.  Kraft broke up into a slow-growing domestic business that paid a high dividend (designed to attract dividend investors) and a faster-growing international snack food company (designed to attract growth investors).

I personally find all of these theories behind the excellent performance and the phenomenon itself fascinating.  I continue to take a close look at any spinoff situations that I become aware of for potential investment opportunities.

Thanks for reading everyone.  Have a great evening!

Deej

13 Comments – Post Your Own

#1) On February 26, 2013 at 5:00 PM, Mega (99.96) wrote:

Interesting topic. Although pinpointing the exact reasons may be difficult, it should be fairly easy to determine what percentage gain comes from multiple expansion versus operational performance. Seen any studies that address that?

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#2) On February 26, 2013 at 5:11 PM, somrh (86.39) wrote:

Sort of related to Megashort's question (or perhaps this is what he has in mind)....

Suppose that, as you've said, there isn't a huge sell off in spin-offs. Yet all of the event driven hedge funds plus all of the retail investors just know that spinoffs outperform so they bid them up after the fact. Then perhaps some momentum/technically driven buyers jump on board to drive the price further. And that's what drives their outperformance.

So I'd be curious about actually long-term buy & hold performance of spin-offs. If I buy a basket of spin-offs this year, will I earn an above market (perhaps adjusted for risk) rate of return in the long-term? 

Is the multiples expansion justified?

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#3) On February 26, 2013 at 5:18 PM, TMFDeej (99.32) wrote:

Hey Mega.  I haven't seen any studies about where the gains come from, but you're right, one should be able to calculate that if they wanted to and had enough time.

Deej

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#4) On February 26, 2013 at 5:22 PM, TMFDeej (99.32) wrote:

The self-fulfilling prophesy.  I like the theory somrt.  So many people "know" that spin-offs outperform that they buy shares en masse, causing the stocks to rise faster than they normally would or should.  It's definitely possible. 

As long as it continues to work, I'll take it ;).

Thanks for the comment.

Deej

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#5) On February 26, 2013 at 5:29 PM, Mega (99.96) wrote:

If I buy a basket of spin-offs this year, will I earn an above market (perhaps adjusted for risk) rate of return in the long-term? 

The study that post linked to suggested the outperformance was 15% in the first year, then 5% over the next two years.

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#6) On February 27, 2013 at 12:58 PM, lemoneater (78.14) wrote:

In my limited experience spin-offs like SE seem to be profitable much more quickly than other kinds of IPOs that are for totally brand new companies like VUOC. Perhaps it's like comparing a teenager to a baby. Spin-offs already have more mature business plans, experienced personnel, commercially viable products, and a developed customer base--benefits that other startups may not possess.

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#7) On February 27, 2013 at 7:18 PM, DirkaDirka (74.35) wrote:

Spinoffs certainly aren't secrets anymore, but I'd still venture that they're under-covered initially. By some numbers the AbbVie spinoff was the largest ever, but there were no CNBC alerts on the first day of trading like you see with even small IPOs. That spin still had a good share of coverage, but most you'll never hear about without looking on purpose. 

 Also, spinoff prices are initially set by the market, whereas IPOs are priced by the offerer and then the market does the adjusting. My completely unscientific observation of IPOs is they often skyrocket initially and then are brought back down to earth when the hype dies. Spinoffs seem to be very nearly the opposite. It at least explains the initial market inefficiency.  

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#8) On February 27, 2013 at 11:28 PM, HotRodd (< 20) wrote:

amazing write up Deej!

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#9) On February 28, 2013 at 1:26 PM, Mega (99.96) wrote:

Speaking of spinoffs, Leucadia just spun off Crimson Wine Group (CWGL) in preparation for the merger with Jefferies. I've asked TMF to list it on CAPS.

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#10) On February 28, 2013 at 4:18 PM, Mega (99.96) wrote:

http://caps.fool.com/Ticker/CWGL.aspx

http://boards.fool.com/cwglv-comes-to-town-crimson-wine-group-ltd-30561511.aspx?sort=whole

http://biz.yahoo.com/e/130226/crswv8-k.html

http://crimsonwinegroup.com/

Mildly profitable, trading around tangible book value.

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#11) On February 28, 2013 at 4:35 PM, TMFDeej (99.32) wrote:

Thanks HotRodd!

Deej

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#12) On February 28, 2013 at 4:40 PM, TMFDeej (99.32) wrote:

Thanks for the info on Crimson Wine, Mega.  I looked at it a couple of times over the past several weeks after I believe it was you initially brought it to my attention.  I really want to like it, but I'm just not buying it at this level.

What we have in Crimson is an OTC stock in a pretty crummy business that has some solid land assets, but they appear to be pretty fairly valued at this level.  If this thing tanked like a spinoff is supposed to then I might be inclined to buy ;).

I just added it to my seldom watched Watch List.  It looks fairly volatile, down at one brief point more than 15%.  Perhaps I should put in a super cheap buy order and see what happens.

Deej

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#13) On March 01, 2013 at 6:44 PM, TeenStockPicker (64.51) wrote:

Any thougths on Zoetis (ZTS)? Pfizer spin-off of animal care unit...

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