Some of my most profitable investments are not based on stocks purchased but on stocks acquired via “spin-offs” from companies already owned.
A spin-off is created when a firm sheds a business unit and transfers ownership to existing shareholders. The amount of shares you receive in the new entity is based on the number of shares held in the former parent firm. Spin-offs are usually distributed tax-free: taxes are not due until shares are sold. But you’re not getting something for nothing. It is like taking a dollar from your wallet and putting 72¢ of it in your left pocket and 28¢ in your right. It is the same pie, only divided differently.
Firms have many reasons for spinning off units, but the most frequent is the belief that the deal will unlock value. In other words, the two companies will be worth more separately than they were in their combined state. In some instances, the parent company wants to highlight the value of the businesses it is spinning off, believing the market will value the sum of the company’s parts greater than it has valued the whole company. Companies also will spin-off non-core businesses to clean up their image in the marketplace. This is often viewed as a convenient way to dispense of underperforming units, and these spins are generally not well received by the market. However, with independence from a parent that has failed to provide the capital or management focus to nourish it, these businesses can substantially improve their prospects within their industries and turn a bargain-priced investment into a big winner.
In one of the biggest breakups of a business ever, AT&T was split into seven Baby Bells. In this case, regulators, for antitrust reasons, ordered an end to the company’s monopoly on local phone service. A more common reason for mandated spin-offs is the need to gain regulatory approval for a merger. Firms may also spin-off assets to focus on their core business and to remove a slow-growth or capital intensive operation.
Certainly, not all spin-offs prove to be attractive investments, but a fair amount of research has shown that investors should not be quick to dump the spin. One reason for the strength of these businesses is the power of independence. A company that is set free from a larger corporation has the chance to flex its entrepreneurial muscles. Management typically has extra incentives in the way of stock options in the new entity.
In addition, spin-offs tend to outperform because they are often inefficiently priced to begin with. The newborns are frequently sold by investors or under-followed by analysts for reasons unrelated to the investment merit of the company. Shares may be dumped because they do not meet an investor’s portfolio requirements. Mutual funds that track an index like the S&P 500 are usually forced to sell because the new stock is not included in the index. Similarly, a large-cap portfolio manager may discard a spin-off because the market capitalization of the company is too small.