I have written and evaluated spun-off companies as value ideas. In this post I want to elaborate on the rationale and the value in spin-off investing. A good book that details this subject is Joel Greenblatt's book "You can be a stock market genius". If you can bypass the book's over-the-top title, it is actually a very good book in value investing with case studies and good search strategies for undervalued investments.
Joel argues that spin-offs are good hunting ground for value and his three criteria for picking good spin-off companies are:
- Institutions don't want it not because of investment reasons,
- Insiders participation, and
- Hidden investment opportunity is revealed.
Security holders often times invest in parent company for a variety of reasons that may not hold true in the spin-off company, for example, industry, size, leverage...etc. So those holders are motivated to get out from the spun-off company as soon as possible. Typically in the few months after the spin-off there is tremendous selling pressure on the spun-off company for no economic reasons. Selling is done due to investors policies and other limitations.
The rest of the post is an article I saved awhile back but I did not source, so for the author, Please forgive me for not posting credit.
Spin-offs have a limited operating history, which means there’s relatively little for investors to look at as a benchmark for future performance. Moreover, the track record that does exist is likely to be unimpressive, since the parent firm has a strong incentive to clean up its books by allocating lots of ‘grey area’ costs to the spin-off. With a limited and often unimpressive operating history, the market’s expectations are relatively low, which again leads to a lower valuation.
Analysts usually apply a premium to ‘pure play’ niche businesses which spin-off represent. However, this said, analysts will almost certainly never pick up initial coverage. Why? because, the spin off entity does not fall under the initial analyst who covers the parent company’s coverage. E.g. a medical company spinning off a chemical division. The chemical maker will not be under the medical analysts coverage and be too small, or go unnoticed to fall into another’s. This period of ‘wilderness’ for the divested entity is typically 0-9mths after spin occurs. Interesting to note, spin-offs typically appreciate 30% or more in this time. Then a re-rating begins.
Spin-offs are often cheap when they come to the market. Every single one is temporary and most will have nothing to do with the underlying intrinsic value of the business. The hype will eventually pick up if the company performs well, the selling pressure will abate as shareholders of the parent company finish dumping the spin-off’s shares. Analysts will eventually pick up coverage, the company will develop a track record and management generally finds a way to improve a business dramatically after the first year or so. The result is a improved cash-flow generation and sometimes a bit of a valuation improvement as well which often means a nicely appreciating stock price.
- Often, spin-offs are a growth story. If the old management was holding back expansion and the new team has a clear strategy for building businesses that were starved for capital, you can bet the market will reward the risk. Also frequently, there are hidden assets, not reflected in book value, such as land holdings or lucrative brands.
Don’t forget carve outs! They are often a prelude to a full spin-off. In about half of carve outs, the parent eventually leaves the picture.
And don’t forget the parent either! Value can often be released in the parent. It will often set a business free for the most obvious reason. It’s troubled and unprofitable. Usually, the parent unloads the spin-off with baggage ranging from heavy debt to rusting plant and machinery. Incidentally, big debt isn’t a killer if the new company has the earnings to carry it.
Spin-Off Pricing Inefficiency/Technicals
Spin-offs don’t receive much publicity or hype. Typically the parent announces a spin, makes some filings, AGMs, shareholder meeting happen for approval etc.. Then the spin-offs shares quietly show up in the accounts of investors and institutions who own the parent. There’s generally not much news coverage when a spin-off hits the investor’s accounts and the valuation is set by the parent.
The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people. Once the spin-off’s shares are distributed to the parent company’s shareholders, they are typically sold immediately without regard to price or fundamental value.
Structural selling of spin-offs happens due to index fund selling (because the spin-off is not in the index) Lack of yield limited old lot selling and limited liquidity.
- In the Penn State study, the largest stock gains for spin-off companies took place not in the first year after the spin-off but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spin-off’s stock can perform at its best. Most likely, though, it is not until the year after a spin-off that many of the entrepreneurial changes and the initiative can kick in and begin to be recognised by his marketplace. Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spin-offs, there is more then enough time to do research and make profitable investments.
When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spin-off, stock options, whether issued by the spin-off company or the parent, can more directly compensate the management of each business.
Shares of a spin-off are distributed directly to parent-company shareholders and the spin-off’s incentives-stock-option plan is based on this initial trading price. The lower the price of the spin-off, the lower the exercise price of the incentive option. To promote interest in the spin-off’s stock after this price is set by the market, not before.
Do not expect bullish pronouncements or presentations about a new spin-off until a price has been established for management’s incentive stock options when the price of management stock options is to be set.There are few investments areas where insiders have such one-sided control in creating am new publicly-traded company.
Many spin-offs are run a lot better as independent companies than as wards of huge corporations. You attract far better managers to a spin-off than to a division of a company. People can really see they’re making a difference in the value of the stock and their own stock options.
These four criteria can hint at an attractive spinoff: