The following is an excerpt from, “Spin-Offs—Finding Buried Treasure in Corporate Discards,” which can be found at kirrmar.com.
As “value” investors, we’re always attempting to buy $1 of intrinsic value for 50 cents. We look for stocks with limited Wall Street recognition or sponsorship or that are otherwise out of favor.
We have had success investing in spin-offs for more than three and a half decades. Our experience has been that corporate restructuring events often create market inefficiencies, allowing us to buy at a significant discount to our evaluation of intrinsic value. Many investors look at spin-offs as corporate waste, an orphan pushed to the side to let the parent company shine.
We see it as the exact opposite.
A spin-off can come in many different shapes and sizes, but the end result is the same: a parent company distributes all or most of its ownership of a subsidiary to the parent’s shareholders. In the process, a new, independent company emerges.
There are two primary reasons why a company may choose to spin off a subsidiary. If the businesses of the parent and subsidiary are unrelated, separating the businesses by spinning off the subsidiary can enable investors to better understand and appropriately value each. In other words, a spin-off can create parts with a combined market value greater than the present whole.
A spin-off can also separate a “bad” business from a “good” business. This frees management of the good business from worrying about the bad business. Concurrently, the bad business’ management team can focus solely on improving its operation, unshackled from the constraints of the combined entity.
Once a subsidiary’s shares are distributed to the parent company’s shareholders, they are typically sold immediately, with little regard to price or intrinsic value. The reasons for this knee-jerk selling are many. All in all, the spin-off process is a fundamentally inefficient method of distributing stock to the wrong shareholders.
This indiscriminate selling leads to a market inefficiency that can be exploited. If you are willing to invest the time and effort, the potential for significant outperformance over time is great.
A spin-off can unleash entrepreneurial forces in the subsidiary. Incentive awards tied to the parent company and/or its stock may not mean much to managers of the subsidiary. However, with independent financial results and separate stock price, the concept of accountability takes on a whole new meaning.
There is a body of academic study and Wall Street analysis of spin-offs occurring as far back as 1965 that shows stocks of spin-off companies significantly and consistently outperform the market averages.
This research also indicates spin-off stocks outperform versus similar market capitalization stocks in the same industries. One reason may be evidence that “strongly suggests that spin-offs are accompanied by substantial improvements in operating performance and profitability.” In addition, parent firms and their spin-offs were five times more likely to be taken over than other companies.
This performance anomaly persists to this day. From its inception on Dec. 31, 2002 through June 29, 2012, the Bloomberg U.S. Spin-Off Index had a total return of 243.5 percent versus 87.4 percent for the S&P 500.
How can this anomaly continue if investors know it to be true? It’s the same reason value investing outperforms growth over a long period of time. It’s hard work combing through and analyzing a thick SEC filing. By definition, you’re buying something that has been discarded and is out of favor.
However, if you have the stomach and psyche for investing in spin-offs and are willing to do the work, there can indeed treasure buried in corporate discards.
Mickey Kim is the chief operating officer and chief compliance officer of Columbus-based investment adviser Kirr Marbach & Co. He can be reached at 376-9444 or firstname.lastname@example.org.
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