Why Do Spinoffs Outperform?
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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:
Whew, that's a lot of companies. Sometimes this strategy works out very well, like with Kraft and TYC, 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 http://falkenblog.blogspot.com/2013/02/the-spin-off-anomaly....) 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 Motorola split. Motorola 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.
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