Monday, 23 July 2012

The Opportunities in Spin-offs

Spinoffs can take many forms, but usually involve a conglomerate breaking one collection of businesses into two or more smaller ones, or a parent company carving out a subsidiary or large division to operate independently.  The major motivation is the hope that the businesses will be valued higher separately than together.  Conglomerates, for example, often own businesses of varying quality in several different industries.  Since investors cannot invest directly in the top-tier companies without also taking a stake in the dogs, many will ignore the company altogether, and the share price will remain depressed.  Mary Buffett and David Clark liken it to finding "hidden diamonds wrapped in ugly coal" (Arbitrage, p115).  Spinoffs allow investors to attach an appropriate value to each business, and even accounting for the fact the poor businesses will be valued accordingly, the collection of freestanding businesses will often be trade at a higher value than the single entity did.

Spinoffs are currently back in vogue.  In the past year or two, a number of large and familiar companies have decided to break up into two or more smaller entities.  Kraft Foods, for example, decided to separate its fast-growing snacks business from its steadier, but slower moving, grocery operation.  ConocoPhilips separated its downstream assets, which include refining, marketing and chemicals, from its exploration and production business.  Recently, News Corp decided to divide its publishing arm from its entertainment businesses.  Wise investors will take a long look at these - and similar - opportunities.  After all, a number of prominent and successful investors have found opportunity in spin-offs, including Peter Lynch, Joel Greenblatt and Warren Buffett. 

The case for spin-offs is compelling.  Joel Greenblatt cites one study, covering a twenty-five year period ending in 1988, which showed that spinoffs outperformed the index by 10% per year in the first three years as stand-alone businesses.  The stock market has returned 7-8% per year over the long-term.  A random basket of spinoffs would return a much more attractive 17-18% per year.  This is a major difference.  $1000 growing 7.5% per year would amount to $8755 after 30 years; that same amount growing for 30 years at 17.5% would be worth a staggering $126 222, more than 14 times the alternative.  And truly ambitious investors will try to do still better: rather than settling for the indiscriminate bunch of spin-offs, separating the ordinary from the most appealing might earn a few extra percentage points per year.  An additional three percentage points would bump up the annual return to 20.5%, and boost the overall amount to $260 913.
Why is this so?  In part, it's due to multiple expansion: a diamond covered in soot is likely to be valued like coal, but when the two are separated, the hidden gem will command a sparkling P/E ratio.  The underlying business itself has a good chance of improving, too.  Free to succeed or fail on its own, a newly-divested company will benefit from the full-time focus of management, and the entrepreneurial forces that may have been stunted within a large and lumbering bureaucracy can be unleashed.  In some cases, financial engineering will be used to distinguish the good from the bad and the ugly.  For example, sometimes one of the newly single companies will be deliberately overloaded with debt, freeing the remaining business(es) from the burden of leverage.  Of course, this sort of idea can easily be taken too far, and an excessively debt-laden company may not be able to survive.

There are different ways to go about investing in spin-offs.  In Warren Buffett and the Art of Stock Arbitrage, the authors report that Buffett prefers to buy stock in the parent company before a spin-off is executed; afterward, he sells the parent and keeps the coveted small-fry.  For example, when Dun & Bradstreet spun off Moody's over a decade ago, Buffett bought-then-sold the parent, and held his interest in Moody's, a position that has since trounced the overall market, and which he continues to hold.
Greenblatt, however, tends to buy spun off businesses after the transaction has occurred.  Most spin-offs are much smaller than the parent, though most investors are interested primarily in the larger business.  When the new business is divested, many will suddenly hold a position in an unwanted company.  (Shareholders will own a proportionate stake in all companies after such a transaction: an investor who owned 1% of the parent company before the spin-offs, for instance, will own 1% of each different company afterward).  Moreover, many institutional investors are too large to bother with a small company, or they are banned by statute from holding businesses below a certain threshold (say, under $1 billion in market capitalization).  The automatic selling usually puts downward pressure on the spun out stock in the first year or so after the transaction.  For Greenblatt, buying at depressed prices in the inaugural year is ideal.  As a bonus, at about the time the knee-jerk selling ends, some of the typical improvements in the underlying business begin to bear fruit, and the stock often heads upward.

Greenblatt has found other ways to profit from spin-offs, too, including by investing in the parent companies, by buying into some of the highly-leveraged businesses seemingly left to die, and by devoting capital to partial spin-offs.  Profit-hungry investors would be wise to read Greenblatt's book You Can Be a Stock Market Genius.  Not only is it one of the finest investing books ever conceived, the chapter on spin-offs offers the best coverage on the topic I've yet read, including several long and fascinating case studies from his career. 
There are thousands of publically traded corporations in North America, many of which are bought, merged and sold every day, making it difficult to track pending spinoffs.  Happily, there are several websites devoted to following them.  After a company announces a spin-off, regulatory filings will be published that outline at least the broad financial performance of the soon-to-be-separate businesses.  Investors that routinely consult these filings will find a world of opportunity, at least over a long period of time.

I wrote an earlier book review of Warren Buffett and the Art of Stock Arbitrage.

Sources: (1) Buffett, Mary and Clark, David. Warren Buffett and the Art of Stock Arbitrage: Proven Strategies for Arbitrage and Other Special Investment Situations. New York: Simon & Schuster, 2010.
(2) Greenblatt, Joel.  You Can be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits. New York: Simon & Schuster, 1997.
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