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In November 2006, Verizon (NYSE:VZ) spunoff its directories business into a new entity called Idearc (IAR). I see a lot of upside potential in IAR and believe it offers a nice risk-reward scenario.

Spinoffs have historically outpeformed the market for a variety of reasons. This often occurs because the stock is not widely followed after heavy institutional selling is not based on the stock's investment merits, thus creating a pocket of market inefficiency for us to exploit. Additionally, management in many cases is given strong incentive to perform with a large portion of the newly created entity's stock allocated to management. Often times in spinoffs the new company has debt from its parent layered on its capital structure, which creates a leveraged finance type opportunity. By buying at a margin of safety, we can create an asymmetrical risk reward scenario.

In fact, Idearc shares several of these characteristics common in spinoffs. Its market capitalization is only a billion dollars, which makes it far smaller than Verizon, and has forced large institutions, regulated by investment charters that say they can only invest in large capitalization stocks, to sell. A large portion of Idearc's shares, approximately 40% of the float, have been allocated to management tying their compensation to their performance, and giving them strong incentive to do a decent job for shareholders. It also has been given a large amount of Verizon's debt, which has created the leveraged finance type play I mentioned above, and will enforce managerial discipline.

And, of course, a directories business sounds so boring it puts the average investor to sleep. Together with the fact that IAR has too small a market capitalization for institutions to have in their portfolio, it will not be widely followed.

IAR 2-mo chart
IAR 2 mo chart

Disclosure: Author is long IAR.

Source: The Long Case For Idearc