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.

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

Book Review - Warren Buffett and the Art of Stock Arbitrage, by Mary Buffett and David Clark

Warren Buffett is widely known for investing in high-quality businesses with a sustainable competitive advantage, a high return on capital, run by able and honest managers, and selling at a bargain price.  When he's able to find such gems, he likes to hold them long-term, ideally "forever."  His success in arbitrage and special situations investments, however, is not widely understood.  In fact, these investments are in some ways the very opposite of his usual focus, as they offer only a one-time, short-term opportunity.  A study of Buffett's investments from 1980 to 2003 found that the average investment returned 39% per year, but the average arbitrage deal returned an incredible 81%.  Without such investments, his overall performance would have fallen significantly, from 39% to 27%.  In Warren Buffett and the Art of Stock Arbitrage, Mary Buffett and David Clark set out Buffett's criteria for making such investments.

Buffett has focused on three forms of arbitrage - friendly mergers, hostile takeovers, and corporations making tender offers for their own shares - and four kinds of special situations - spinoffs, liquidations, stubs and reorganizations.  Arbitrage is a broad term that refers to an opportunity to capture a spread between two prices, such as gold selling at a higher price in one market than another, even when accounting for currency differences.  But Buffett pursues stock arbitrage, where the price being offered for a security is higher than the price currently prevailing in the market.  If Company A, for example, offers to buy Company B for $100 per share, B's stock may settle around $95.  The $5 spread, which exists because there is always some uncertainty - financing, regulatory, legal etc. - about whether the deal will successfully close, offers arbitrageurs the chance to profit.

Buffett considers arbitrage deals once they've officially been announced, and acts only if he feels there's a high probability that the transaction will be completed.  His analysis boils down to a few variables.  On the upside, he calculates the likelihood the deal will be completed, the percentage return, and the approximate amount of time to completion.  On the downside, having already estimated the likelihood that the deal goes through as planned, the major factor left to figure out is how far the stock will fall if the deal fails.

Returning to the above example, the upside for arbitrageurs in Company B is 5.3% (5/95).  Assuming the deal is certain to close in six months, the annualized (non-compounding) return would be 10.6%.  Since most other investments are quoted in annual returns - on bonds, in the stock market etc. - this return could be compared to other potential investment opportunities, as well as alternative arbitrage deals.  (The calculation becomes somewhat more complex when adjusting for the probability of the deal closing as planned, as set out in the book's fifth chapter).  The basic concept holds for stock-for-stock deals, cash offers, and hybrids.

The math's laughably easy, but estimating the probability that a deal will close can be tricky.  Any deal faces several possible hurdles: legal impediments could nix a proposal, financing could fall through, shareholders could reject the deal, and so on.  Friendly mergers are most likely to close, since shareholders tend to vote in favor of proposals that are endorsed by management and the board.  Of those, Buffett prefers self-financing, strategic buyers that are pursuing a company to complement their existing business - think Procter and Gamble's purchase of Gillette - rather than hedge funds or LBO firms that rely heavily on financing which might dry up unexpectedly in tough markets.  Buffett is wary of deals that might attract serious scrutiny from regulators or anti-trust commissions: not only do prolonged investigations erode the time value of money, they occasionally scuttle a deal altogether.  While not all stars must be perfectly aligned - Buffett has even played hostile takeovers in the past, though rarely - these are the basic parameters that he looks for.

Buffett has also found opportunity in companies changing form, usually from corporations to royalty trusts or master limited partnerships (MLP).  Surprisingly, the market often doesn't immediately recognize the shift with an increased stock price until after the change has been made, even though the transformations are usually almost certain to be implemented.  The authors helpfully offer an example of Buffett's investment in each situation - Tenneco, a natural gas producer, which converted to a trust, and Service Master, a collection of different businesses that became an MLP - and his approximate return.

Additionally, Buffett has invested in spin-offs, where a company that owns multiple businesses breaks into two or more stand-alone firms that figure to be worth more separate than together.  Buffett's interest in spin-offs lies in the chance to acquire excellent businesses that have previously been unavailable to invest in directly.  Buffett takes his position in the parent company before the spin-off occurs, then sells the parent and holds the new stand-alone firm.  This is just what he did, for example, when Dun & Bradstreet spun off Moody's in the late 1990s.  This chapter is thin on analysis, and leaves important questions unanswered: for example, why doesn't Buffett wait until after the spin-off has concluded to purchase the preferred company, as Joel Greenblatt has done with great success? 

Given that Buffett is the greatest investor in history, any serious book about his methods is worthwhile.  However, nagging questions sometimes remain about just how accurate Buffett commentators are.  For example, on the all-important matter of how he values a business (not a concern in this particular book, granted) Buffett and Clark offer one explanation (found in Buffettology), Robert Hagstrom another (basically a standard discounted cash flow model) and Alice Schroeder still another (according to her, he requires a 15% return, and makes a "yes-or-no" decision accordingly).  All are leading authors on Buffett, yet offer differing accounts on a basic and important aspect of his approach, leaving students of investing puzzled. 

Despite the authors' past work on Buffett and their personal ties to him - Mary Buffett was married to Buffett's younger son, David Clark has been a long-time Berkshire Hathaway shareholder and student of Buffett, and they refer to him in the book familiarly as "Warren" - this book prompts a few similar doubts in places.  There's little sign that Buffett participated in this book's creation, made factual corrections or personally endorsed it.  There are other clues that the authors reach conclusions based on deduction, rather than first-hand conversations with Buffett.  For example, when discussing his 1998 investment in a liquidating REIT, they state, "Warren would have had five thoughts..." (104). There’s ample reason to suspect that their after-the-fact re-creations are largely right, but Buffett's thinking may have been different from what the authors imagine.  It would have been helpful if they'd been more forthcoming about the evidence they used to arrive at their conclusions, ideally in the form of footnotes.  Though there are no obvious errors, parts of the book seem slightly vague.

Still, Mary Buffett and David Clark have written yet another first-rate book on Buffett, and have illuminated one of the few remaining areas of Buffett's career that hasn't been widely studied.  In just over 140 short pages, they cover a range of non-standard investments that Buffett has made, while offering enough detail for investors to begin pursuing similar opportunities.  Though picky readers may have some small doubts about Buffett's precise methods, the authors discuss each topic clearly and knowledgably.  Besides, Clark runs a partnership that pursues special situation investments, so he brings insight of his own to any areas where Buffett's approach may not be entirely clear.  To complement the theory that fills most of the book's pages, they offer practical advice about how to search for ideas, what relevant filings to study, and how events such as tender offers play out in reality.  Overall, Arbitrage lives up to the high standards that Buffett and Clark have set for themselves in their past work.

Source:

Buffett, Mary and Clark, David. Warren Buffett and the Art of Stock Arbitrage: Proven Strategies for Arbitrage and Other Special Investment Situations.  New York: Scribner, 2010.

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.