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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