Back in the 1960s conglomerates were all the rage. These large companies encompassing multiple diverse businesses were thought of as strong investments because they had the ability to withstand cyclical weakness in one or more of the sectors represented by one of its business lines and still produce positive returns.
The case for conglomerates is an old and simple one: Diversification. However, this diversification often comes at a cost. Joe Cornell founder and CEO of Spin-Off Advisors writes, “The market often applies a haircut to the value of widely diversified companies. Frequently, conglomerates trade at a discount to more focused companies. The conglomerate discount gives investors a good idea of how the market values the conglomerate as compared to the sum value of its various parts.”
Cornell points out that by the 1970s, the market had begun to turn away from conglomerates, a trend that gained steam in the 80s and 90s. By the time Cornell began his career as an analyst at boutique hedge fund Keeley Asset Management in the early 1990s, he was tasked with researching potential spin-offs. “It was a small firm and the owner, John Keeley, had a couple of little small cap value funds and was a big believer in investing in spin-offs, bankruptcies and restructuring themes,” Cornell says. “I got turned on to spin-off investing and found it to be very inefficient and not covered very well by conventional Wall Street types.”
Basically, Cornell saw an open field where he could gain an edge because there were very few analysts researching the space. “I saw a lot of examples of this working out, a light bulb went on over my head [and] I spun myself out of John’s firm,” he says.
He adds, “The multiples of conglomerates have been low but you might have a lot of good businesses that would trade at a different multiple if it was separate. That has been a driver, the market is not valuing us properly; let’s get this out in the sunshine and let people decide what the proper valuation is.”
With few analysts looking into spin-offs, Cornell knew he found a unique niche and created Spin-Off Advisors in 1997, a consultancy that provides research on announced spin-offs. When he launched the advisory he also built a small hedge fund that invested in spin-offs, but found explaining the potential conflicts cumbersome, so he decided to focus on the research side as it was the driver of profit. Cornell still invests proprietary firm money in the spin-off sector.
The spin-off edge
Cornell wrote a book — Spinoff to Payoff: An analytical Guide to Investing in Corporate Divestitures — to help promote his new venture. In it he wrote that spin-offs had gone from a technique to eliminate poor performers to becoming a means of unlocking value. “At the time, 1999-2000, when the tech boom was going on, it was a way to highlight value in stocks,” he says.
He describes two bookends to spin-off drivers. “It could be something that is good that is not being valued properly within the parent company because it is not obvious and if you get it out in the sunshine people can put a valuation on it, or [you] want to get rid of the red-headed stepchild in the portfolio that is taking too much attention and that will enhance the parent’s valuation,” he says.
So, spin-off value could be driven by the new company spun, the parent could be freed from a poor performing asset or a combination of both.
What he found, though, is that there was a lot of hidden value in spin-offs and his research at the time showed spin-offs significantly outperformed the broad market. That outperformance has persisted despite the strategy becoming more popular (see “Spinning off alpha,” below).
“Sometimes you get these fundamentally [strong] businesses that were buried in something else, they kind of wither a bit,” Cornell says. “Once they are out on their own there is a lot of turnover in the shareholder base. “
In the early days of spin-offs, the play was to wait for a value play as the spun company often initially tanked. “They get kicked out of indexes, there is no street coverage because there wasn’t an IPO and people are confused [because their broker doesn’t cover them],” Cornell says. “This was a way to get parts off of the books. Giving your investors a hot potato — they just wanted to get rid of it and sold it.”
Often the weakness is based on managers getting a new asset that they did not select, did not research and that does not match their selection criteria. For instance, a program could be attempting to replicate the S&P 500 and though the parent qualifies, the spin-off does not. Managers would sell the spun company because it was not something they were mandated to consider — it had nothing to do with the quality of spun stock or an analysis of its value.
“You have a lot of natural sellers, not a lot of natural buyers,” Cornell says. “With that dynamic sometimes you can find companies that trade at a discount to what they are worth. That is what we are looking for. Once they are out on their own, we find the dynamic is a lot different.”
Once free the spun company can act in its own interest, rather than just as a cog in a machine. “Management is better incentivized, they get stock options on that specific stock, that ramps up the entrepreneurial zeal, they bring new products,” Cornell says. “It is typical that with a spin-off that in 18 months to two years, the operating performance improves. If they are below their peer group they often get within the peer group. “
And remember that spin-offs often have taken a severe initial hit in value for no particular reason other than they are new and unknown.
“They sunk like rocks for six months,” Cornell points out. “And then if a spin-off could get the ship going in the right direction, get the margins up the debt payed down; [there was value].”