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Spin-offs often make for interesting investments. There are not that common, but tend to perform well, especially in their first couple of years as a stand-alone stock. This has been written about in a few areas, and specifically by investor and author Joel Greenblatt, as this type of stock is one of his favorite investments.

Let's look at what spin-offs are and why they outperform.

Spin-Off Advisors, a company that specializes in research and portfolio management of spin-offs, define them as this:

In a pure spin-off, a parent company distributes 100% of its ownership interests in a subsidiary operation as a dividend to its existing shareholders. After the spin-off, there are two separate, publicly held firms that have exactly the same shareholder base. This procedure stands in contrast to an initial public offering (IPO), in which the parent company is actually selling (rather than giving away) some or all of its ownership interests in a division.

Barron's ran a cover story about spin-offs back in March 2006. In that article, they found some interesting results:

A study by Lehman Brothers strategist Chip Dickson of 88 spinoffs between 2000 to 2005 found that they beat the S&P 500 by an average of 45% in their first two years as independent companies. The group evaluated contained only spinoffs -- no carve-outs -- and was drawn from the top 1,500 companies in the stock market. A larger group, dating back to 1990, topped the benchmark average by 18%.

Spin-offs don't often get hyped the way an IPO would, as stock is being handed to current shareholders of the larger entity. These shareholders are often indifferent about the new company and tend to dump the shares.

Here's a little more detail on this, again from Spin-Off Advisors:

The spin-off process is a fundamentally inefficient method of distributing stock to people who may not necessarily want it. For the most part, investors were investing in the parent companies business. Once the shares are distributed, often they are sold without regard to price or fundamental value. This tends to depress the stock initially. In addition, institutions typically are sellers of spin-off stocks for various reasons (too small, no dividend, no research, etc.). Index funds are forced to sell the spin indiscriminately if the company is not included in a particular index. This type of selling can create excellent opportunities for the astute investor to uncover good businesses at favorable prices.

So you have an under-hyped stock that often sees depressed prices due to new shareholders dumping the stock. The case for picking up the stock at a good price is there, but the company still has to perform well, and many spin-offs do. This can be due to a few reasons. The Barrons article sites a few of them:

  • Why do spinoffs outstrip the market? Dickson thinks they benefit from greater management focus and accountability as stand-alone public companies than they had when they were part of larger enterprises. In a like vein, Cornell argues that many spinoffs were larger companies' neglected stepchildren.
  • Spinoffs tend to be relatively small operations -- only one deal, Ameriprise, exceeded $10 billion last year -- and therefore are off most investors' radar screens.
  • There often is little or no initial coverage by Wall Street analysts of spinoffs, perhaps resulting in greater inefficiencies in their valuations, especially for those valued below $1 billion. In some cases, institutional holders of the parent reflexively sell the spinoff's shares, because the newly liberated unit isn't part of an index, such as the S&P 500, or because it's deemed too small to merit attention.

To put it simply, the management is motivated to do well. They are on their own as a publicly traded company, and will fall under more scrutiny. This is a good motivator.

I recently reviewed a book called Invest Like a Dealmaker by Christopher Mayer. He often cites Greenblatt and had a portion of his book committed to spin-offs.

He writes, quoting Greenblatt:

Pent-up entrepreneurial forces are unleashed. 'The combination of accountability, responsibility and more direct incentives take their natural course.' Curiously enough, as Greenblatt points out, the biggest gains often come in the second year, not the first. This indicates that it may take some time for the changes to kick in and deliver tangible results.

Spin-offs can unlock hidden demand for a company as well. The spin-off is likely a pure-play on something and isn't engaged in a group of industries like its parent was. The stock will likely find buyers who wanted to own this business, but never before had direct access. I think of a company like GE. Many people talk about their alternative energy businesses or industrial businesses, but you can't buy them alone, you have to buy GE stock. This frees up that demand.

So how can we invest in spin-offs? Well, you can keep an eye open for them and buy stock in the individual company once the spin-off has occurred, if you like the company.

There is also an ETF option. Claymore funds created the Claymore/Clear Spin-Off ETF (NYSEARCA:CSD). This tracks the Clear Spin-Off Index. The fund is small and lightly traded, but does own stakes in recent spin-offs, and their largest holdings are:

  • METAVANTE TECHNOLOGIES (MV) 6.03 %
  • DR PEPPER SNAPPLE GRP WI DPSW (NYSE:DPS) 5.77 %
  • TERADATA CORP (NYSE:TDC) 5.69 %
  • BROADRIDGE FINANCIAL SOLUTIONS (NYSE:BR) 5.37 %
  • MSCI INC-A (MXB) 5.17 %
  • VMWARE INC-CLASS A (NYSE:VMW) 4.82 %
  • LORILLARD INC (NYSE:LO) 4.18 %
  • HILLENBRAND INC (NYSE:HI) 4.11 %
  • TYCO ELECTRONICS (NYSE:TEL) 3.96 %
  • SPECTRA ENERGY CORP (NYSE:SE) 3.85 %
  • PHILIP MORRIS INTERNATIONAL (NYSE:PM) 3.84 %
  • WABCO HOLDINGS INC (NYSE:WBC) 3.74 %
  • COVIDIEN LTD (NYSE:COV) 3.74 %
  • JM SMUCKER CO. (NYSE:SJM) 3.73 %
  • KRAFT FOODS (KFT) 3.67 %
  • MF GLOBAL LTD (MF) 3.64 %
  • PATRIOT COAL CORP (PCX) 3.35 %
  • DISCOVER FINANCIAL SERVICES (NYSE:DFS) 3.28 %
  • ECHO STAR HOLDINGS (NASDAQ:SATS) 3.27 %
  • PHARMERICA CORP (NYSE:PMC) 2.58 %

David Einhorn, who manages Greenlight Capital, is someone I follow quite regularly. He also likes to invest in spin-offs. According to Greenlight's latest filing, they own stakes in Echo Star, Discover Financial Services, Patriot Coal, and Teradata. This is another compelling reason for me to look at some of these names.

Overall, spin-offs appear to have a niche in the market that has worked pretty well. I don't necessarily agree with buying stock in spin-offs just because of past spin-off performance, because every company is different. Sometimes a larger company is spinning off a company because they don't want it, and its not in great shape.

So, like any investment, you still have to do your homework. But I do believe in the basic argument for why these work, and some are worth taking a look at for your investment portfolio.

Disclosure: Author does not own shares in any company mentioned.

Source: Why Do Spin-Offs Often Outperform?