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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Book Review - The Dhandho Investor, by Mohnish Pabrai

"What does "dhandho" mean?"  That's likely the first question book browsers ask when their eye catches the spine of Mohnish Pabrai's The Dhandho Investor.  The ethnic group that the word belongs to defines it as a low risk, high return investment, which contradicts the conventional wisdom that outsized returns can only be had at the cost of high risk. As Pabrai likes to say, "Heads, I win; tails I don't lose much."

Many investors have helped affirm Pabrai's motto: the Patels, a people from India that account for just 1 in 500 Americans, but own half of all US motels; Richard Branson, who started serving an ignored niche in the airline industry, while risking little capital by leasing an unused plane; Lakshmi Mittal, who restored dying steel mills to profitability, but paid very little for them; or Warren Buffett, who amassed jaw-dropping returns, while taking on very little risk.  The "high-risk-high-reward" concept has been proven wrong. 

Pabrai is heavily influenced by Buffett and Charlie Munger.  As they do, he encourages investors to buy simple, predictable businesses.  Moreover, worthwhile businesses have a competitive advantage and resulting high returns on capital.  These gems, however, must be bought on the cheap.  Strangely enough, temporary market inefficiencies will give patient investors opportunities to buy gold for the price of brass.  But golden opportunities are rare enough that when they do arise, investors must bet heavily. 

Though Pabrai doesn't break much new ground in this book, he puts more emphasis on certain points than many other investors do.  For example, he broadens the term "arbitrage" from a narrow fixation on price differences, and uses it as a metaphor for investing in general.  What's a competitive advantage, after all, if not a form of arbitrage?  If one company is able to offer lower costs than competitors, it will draw in more customers; over time, though, high-cost producers will perish, and remaining ones will become leaner, narrowing the gap between the market leader and the also-rans.  Fortunately for investors, though, many "moats" last for decades.  Pabrai analyzes GEICO, owned by Buffett's Berkshire Hathaway, which has enjoyed a low-cost "arbitrage" spread for decades, and is likely to do so for decades to come.

One of the high points of the book is Pabrai's discussion of the difference between risk and uncertainty, a crucial distinction that many investors fail to make.  Risk is the potential for capital loss, while uncertainty is a wide range of possible outcomes.  Confusing uncertainty for risk frequently leads to underpriced securities - investors wise to the difference stand to make a lot of money. 

Along with case studies of Level 3 and Frontline, he candidly discusses his investment in Stewart Enterprises, a company that "rolled up" hundreds of locally-owned, mom-and-pop funeral homes, but amassed too much debt in the process.  Worried about the potential of default, the market pummeled the stock.  Pabrai wasn't fazed.  He calmly assessed the company's major alternatives: reselling some locations to their original owners, refinancing, or restructuring via bankruptcy were the most likely options.  Then he assigned a probability to each, and estimated the share price that would result from each option.  He decided that the bankruptcy would leave enough of the business intact to break even, and the other two options would give him a large profit.  Uncertainty was high, but the risk of loss was low.

Pabrai doesn't just vaguely advise investors to bet heavily when the odds are in their favor, he points them specifically to the Kelly Formula as a guideline for how much to wager given certain odds.  Much of the value of the Kelly Formula is that it encourages investors to consider a range of possible outcomes and attach probabilities.  It carries risks, though: it suggests precision, where only approximations can be made, and it suffers from the same "Garbage-in-garbage-out" weakness that many formulas do.  Pabrai recognizes the drawbacks to the Kelly Formula, and he devotes 10% of assets to each investment. (The book was published in 2007.  Pabrai got walloped in the Great Recession, as nearly all investors did, and now runs a somewhat more diversified portfolio).

Most investors agree that selling is an imprecise art.  With the help of the epic poem the Mahabharata, Pabrai offers some wise advice.  First, allow at least two to three years for the story to play out, unless it has become undeniably clear that the investment was a mistake.  Stocks often decline after investors buy them, even when the business is succeeding.  Jittery investors frequently panic and sell, only to watch the stock appreciate later.  In more serious cases, the business itself may stumble.  But all businesses face challenges, and investors must be patient and wait for improvement.  Pabrai did just that with USAP, a specialty steel maker: his investment fell by nearly two-thirds before roaring back and doubling from his initial purchase price.

Many investors offer a recipe for success that's long on theory, but scant on practical advice for finding undervalued stocks.  Pabrai, however, offers helpful suggestions about how to hunt for value: scan Value Line for battered stocks, consult www.portfolioreports.com and www.gurufocus.com for the holdings of prominent value investors, visit Joel Greenblatt's www.valueinvestors.com, www.magicformulainvesting.com and read his book The Little Book that Beats the Market.  Don't be afraid to clone or copycat, Pabrai urges.

Pabrai is an excellent investor.  From 1999 to 2007, he returned 28% a year, though that number has fallen since the Great Recession.  The Dhandho Investor is a success.  He wisely sticks closely to Buffett and Munger, but has the judgment to borrow from others, too.  His book, however, isn't just an collection of other people's ideas, despite his cheerful admission to copying others.  He cites several examples that don't typically make it into case studies, but also draws on more familiar ones.  He reinterprets basic ideas and gives them much more explanatory power.  Short, clear, fun and wise - this book is a must read for any serious investor.

Sources:

(1) Pabrai, Mohnish. The Dhandho Investor. Hoboken: John Wiley and Sons, 2007.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.