Nowadays, Spin-Offs Are Too Often A Gimmick


  • Spin-offs used to be a proven path to market-beating returns.
  • This has been decidedly not true since 2014.
  • Why spin-offs stopped working.
  • Arlo Technologies, the latest spin-off vehicle that crushed investors.
  • This idea was discussed in more depth with members of my private investing community, Ian's Insider Corner. Get started today »

It's one of those established rules of thumb that spin-off stocks outperform the market. Since Joel Greenblatt popularized the strategy, it's become increasingly well-known that spin-off stocks are a great place to find alpha. Numerous studies of spin-offs over the years showed significant outperformance for the average spin-off.

Spin-Offs Aren't So Great Anymore

Unfortunately, and unbeknownst to many investors, spin-offs have stopped outperforming. In fact, I'd argue that many of them are now, actually, value traps. Let's look at two charts. The first is the Invesco S&P Spin-Off ETF (NYSEARCA:CSD) from the fund's inception onward against the S&P 500 (SPY):

ChartData by YCharts

As you can see, the Spin-Off ETF, after a rough go of it during the financial crisis, bounced back strongly and pulled solidly ahead of the market through 2015. Since then, however, things have gone the other direction. Since the Spin-Off ETF's launch, it has now meaningfully underperformed the market as a whole. To be fair, CSD charges a 0.6% annual fee. Add that back and it has just about matched the S&P 500 in returns. Still, spin-offs don't look like a promising land full of alpha based on that. And, zooming in on the past five years, in particular, things get ugly:

ChartData by YCharts

As you can see, spin-offs have turned into a rather dismal strategy lately, putting up only roughly a third of the returns of the stock market as a whole. Since spin-offs span a wide spectrum of industries and business types, there's no inherent reason a basket of them should be badly underperforming simply due to recent market conditions. Rather, something else has changed. But first, let's take a moment to look at the Spin-Off ETF in a bit more detail.

What's In The Invesco S&P Spin-Off ETF?

Folks taking the other side of the spin-off debate may argue that the Invesco S&P Spin-Off ETF with the ticker symbol CSD is not a perfect metric to judge spin-offs by. And that's a fair argument. When constructing an index for a concept like spin-offs, you have to make some judgment calls in terms of composition.

For CSD specifically, they allow spin-offs to say in the index for up to four years after it has started trading independently from the larger company. This is probably longer than many activist investors would stay in a spun-off stock. Perhaps there is some alpha to be regained by trading through spin-off candidates a little more quickly, though that would increase trading costs and tax consequences for a passive ETF. In any case, as of December 31st, 2018, CSD held shares in 46 different securities. As you can see, it has fairly meaty positions in a few large spin-offs that have been public a little while now, such as PayPal (PYPL), Synchrony (SYF), and Madison Square Garden (MSG):

Source: all tables from the fund fact sheet.

Given that is has large positions in some very successful spins such as PayPal and Lamb Weston (LW), I'd have expected to have seen better results for the fund as a whole. Instead, over the past three years, the fund has returned just 4.4% annually against a 9.3% compounded rate of return for the S&P 500 (data as of Dec. 31st). For 2018, the fund lost 18%, compared to a 4.4% loss for the S&P 500.

Looking at sectors, there is no great deviation from the market as a whole either to explain this massive underperformance. Yes, CSD is underweighted in healthcare, but, otherwise, things look pretty reasonable. There's no dramatic concentration somewhere that would exonerate the poor performance of spin-offs recently:

On a valuation basis, you could perhaps argue that the types of stocks that are getting spun off are out of favor. The fund interestingly showed a PE ratio of 12.3x and an ROE of 25% as of December 31st, suggesting that this basket of stocks should be a promising group. Whether that will turn into real outperformance, however, remains to be seen. More broadly, we can say that spin-offs are unlikely to return to their pre-2013 glory days.

Edges Disappear Once They Get Popular

If you have a strategy that reliably delivers alpha, you should get nervous once it gets popular enough that the fund providers start launching ETFs to try to capture it. On Wall Street, any good idea tends to get copied to the point that its returns disappear. You make money, after all, from buying mispriced securities and waiting for them to reach fair value. If there's a large pool of money ready to buy spin-offs because they are "inherently mispriced", then they will stop being mispriced. The demand for spin-offs destroys the opportunity by making their opening price too high.

As a reminder, what are the benefits of spin-offs? Probably the most popular one is that it gives management of the new company incentives to deliver stronger performance. A small unit inside a large conglomerate can barely move the needle. When the head of that unit now has his or her own stock options and performance bonuses, it drives better performance.

Several other factors play a positive role. For one, investors tend to underprice conglomerates. By separating out business units, it allows folks to only buy the specific pure-play business they want exposure to. Oftentimes, a small business within a large company is also essentially lost in the mix. Putting it out as a separate business helps investors see the previously hidden value. Additionally, as spin-offs have smaller market caps, in aggregate, they should outperform as small-caps tend to beat large-caps over time.

Alas, there are some structural downsides to spin-offs. Glenn Chan summed some of them up nicely:

They're gimmicky. Most of the time they lower the intrinsic value of the business due to legal and accounting fees (which I'm not a fan of). I wouldn't bother learning about special situations investing in spinoffs [...]

The SEC filings for a spinoff will state the legal and accounting expenses related to a spinoff. They often cost several millions dollars. In some cases, there are some tricky legal issues in conjunction with the spinoff. There may be concerns that the parent will be liable for the spinoff's liabilities (e.g. asbestos liabilities). Or, the spinoff may create conflicts of interest between the parent and the subsidiary.

From a tax standpoint, it is best to avoid spinoffs so that operating losses at one subsidiary can be used to offset profits at another subsidiary.

There are also some more behavioral downsides to spin-offs that are really making themselves painfully apparent lately. Among them, that activist investors push companies into making fruitless spin-offs just for the sake of doing something. If a business is fully valued, but a hedge fund wants a short-term profit, one way to go about trying to get it is threatening management and forcing them to take action - any action - to placate the shareholder mob. Spin-off activity has soared in recent years in large part due to activist funds going after management.

Additionally, management teams are getting savvy. They realize that investors now have a Pavlovian reaction, assuming a spin-off is good because it is common investing knowledge that spin-offs deliver alpha. When looking at a new spin-off opportunity, investors are biased to like it unless they find glaring red flags. After all, spin-offs outperform, and many investors think this is still a piece of relatively obscure knowledge that can be profited from in 2019.

What does management do, knowing that investors will bid for any halfway-looking decent spin-off by instinct? As the bankers said about launching new tech IPOs during the dot-com boom, you create supply to meet the demand. If investors are buying a product, rest assured, more of it will come into existence to sate investors' appetite.

Too Many Spin-Offs

In 2014, we got a spin-off boom, as the confluence of activist funds run amok and crafty management teams caused corporations to start launching spin-offs at the general public at a frenetic rate. A Barron's article from 2016 summed up the mood well:

Enter the hordes. In 2014 and 2015, spinoffs surged, with 100 new companies launched, often as a result of pressure from activist investors. Spinoffs concocted under duress have a mixed-and occasionally horrible-track record.

The Barron's article rightly noted that, in the past, management teams generally came to the conclusion to execute a spin-off on their own. Now, they were pushing them out simply to please activist investors. Fund manager Kim Scott stated that:

"You don't get the same quality of spinoffs as you do if management and the board have come to that decision without pressure,"

The article also cited Horizon Kinetics CIO Murray Stahl who noted that in the past, many spin-offs were of marginal businesses making little to no money. These were valued by the market at virtually nothing and would gradually gain in value if and when their more focused management teams could turn around. Stahl said that this type of spin-off has largely disappeared and is unlikely to return in numerous quantity until the next recession.

The Spin-Off Machine Keeps Spinning

Despite the huge uptick in spin-off activity in 2014-15 and sharp drop-off in their performance, Wall Street wasn't prepared to let a good thing go. Instead, they've kept firing more and more spin-offs at us. An article from Bloomberg last July noted that:

Soaring markets and the rise of shareholder activism have compelled companies to plan spinoffs at a rate unseen since at least 2008. There's no end in sight for the frenzy as these new stocks keep finding ways to beat the market.

More than 100 companies this year have announced plans for spinoffs on U.S. exchanges, a 54 percent increase from the same time last year, according to data compiled by Bloomberg.

They quoted Edge Consulting Group analyst Jonathan Morgan who stated that:

"The pace of change is set and if the market goes higher, we will see management needing to realize value when valuations are full [...] If markets reverse, companies will still need to look like they are creating value."

That's the real scoop. Management teams are often happy to let overpriced stock go to the public while markets are high. Spin-offs, with their reputation for offering good value, are now a way to push fully-priced stock on value investors who may not be looking at each new offering objectively. Given spin-offs' favorable reputation, as Morgan notes, companies can also engage in them simply to give the appearance of "creating value".

Arlo: The Latest Spin-Off Gone Wrong

I've had this topic on the back burner for a while, waiting for a good opportunity to discuss it. Well, the catastrophic performance of recent Netgear (NTGR) spin-off Arlo (ARLO) gave me the perfect opportunity. Arlo, for those unfamiliar, was Netgear's home security camera division. Netgear is known for stable, but slow-growth, businesses such as internet routers.

As such, Netgear's management decided to spin-off Arlo at the moment of peak optimism last year. At the time, Arlo was showing a 100% year-over-year growth rate, was touting a huge total addressable market, and had a highly anticipated new product launch lined up before Christmas.

Then, the company's new product line was delaying into January, the company returned to making losses, and then this week, it announced disastrous 2019 guidance saying that market conditions have turned sour. The result, the stock dropped 48% on the day and is now down 80% since the recent IPO:

ChartData by YCharts

Perhaps if the market had stayed hot a little longer, ARLO stock would have popped following the IPO, giving Netgear the change to do a secondary offering and unload more of its stock at a favorable price. Or in any case, it would have made Netgear stock look attractive on its own. Remember that until January, when it spun the rest of the stake, Netgear owned 84% of Arlo post-IPO. That stake was, at IPO price, worth $1 billion. Netgear itself is worth less than $1.3 billion today.

Had Arlo stock surged, even for a time, it would have made Netgear stock look really cheap as a sum of the parts play. Netgear's management would have looked like geniuses and perhaps been able to cash out of stock or options for large gains. When any given company knows it can spin off promising business units when the market is frothy, and then investors will buy them up because "spin-offs outperform", it creates perverse incentives. I'm not saying anyone had any bad intentions here, but be aware of the general risks that come with this sort of financial maneuver.

As it is, you need a lot of good spin-offs to make up for every ARLO stock that divebombs 80% within a year of its IPO.

This article was written by

Ian Bezek profile picture
Research and trade alerts from a hedge fund pro with a global outlook.

Ian worked for Kerrisdale, a New York activist hedge fund, for three years, before moving to Latin America to pursue entrepreneurial opportunities there. His Ian's Insider Corner service provides live chat, model portfolios, full access and updates to his "IMF" portfolio, along with a weekly newsletter which expands on these topics.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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