Why Spin-Off Stocks
Usually Out-perform The Rest Of The Stock Market
Spin-off stocks are defined as existing
subsidiaries or divisions that are separated from the parent
company that then become independent publicly-traded companies.
The separation usually occurs as a tax-free distribution to
existing shareholders of the parent company or as an initial
public offering (IPO) by the parent company.
We've personally been investing in spin-offs
since 1993 and started sharing our recommendations in 1998.
The strategy of investing in spin-offs is based on studies
which have shown that spin-off stocks tend to significantly
out-perform the rest of the stock market, but only during
part of their existence. A 25-year Penn State study showed
that stocks of spin-off companies out-performed their industry
peers and the S&P 500 by about 10 percentage points per
year. A study by Lehman Brothers showed that spin-offs returned
18.2% above the S&P 500. And as Joel Greenblatt points
out in his questionably-named (but worthwhile) book You
Can Be A Stock Market Genius, most institutional investors
are unable to invest in spin-offs for various reasons (more
on this later). Since the vast majority of trading volume
is done by institutional investors, the universe of spin-off
stocks is mostly left to the individual investor to exploit.
On average, stocks return about 9%-10%
per year. Spin-off stocks average about 19% per year according
to the Journal of Financial Economics. The spin-off stocks
we've recommended (see our Primary
Stock Portfolio) have provided an average return of
31.9% per year, easily beating
the market each year since 1998. Our spin-off purchases
and subsequent sales have resulted in an average gain of
73.5%with
70.3%of the trades being profitable. There's even a class of spin-offs
that we reject as being too risky that have returned
47.9%per year. We classify these spin-offs as Speculative
Spin-offs. But why do spin-offs outperform stocks in general?
Why Spin-Off Stocks Usually Outperform
Most businesses are run better when they
are out from under the parent company's control. Often the
parent company provides little freedom or capital for the
subsidiary to thrive prior to the spin-off. But once the subsidiary
has been spun off, it is free to make its own decisions without
having to obtain the parent's consent. The independent spin-off
often out-performs the parent company, especially if the spin-off
company's management has been given an opportunity for a big
payday based on the performance of the new company. This is
usually accomplished with options, stock appreciation rights,
restricted stock, or an ownership stake. This even creates
an incentive for the spin-off's management to downplay the
company's prospects prior to being separated from the parent
company. This would be done to get management's initial options
to be priced as low as possible in order to maximize management's
monetary reward down the road.
When a company is spun off, there are usually
very few Wall Street analysts covering the stock, if any at
all. With few people analyzing these stocks, it's easier to
find the hidden values. Think of it as looking for bargains
at a yard sale. Would you rather arrive at the yard sale at
the end of the day when many other people have already searched
through the items looking for potential treasures? Or would
you rather show up two hours before the yard sale is open,
before anyone else has had a chance to look for undervalued
goodies? Triad Hospitals
Inc. and LifePoint
Hospitals were two examples of spin-offs with little analyst
coverage. A $2,000 investment in either of these companies
grew to over $7,300 in three years.
A large part of the market's trading volume
is done by investors (both individual and institutional) using
screening software to filter out a large percentage of the
stock universe to narrow down the number of stocks they will
then analyze in a more thorough manner. When a company is
first spun off, there is usually insufficient published data
for the stock to be included in the screening software, therefore
spin-offs don't usually show up on investor's radar until
the company has had time to mature.
Many spin-offs are focused "pure play"
companies that operate in a niche area. This tends to attract
buyout offers. In fact, spin-off stocks are four times more
likely to be bought out when compared to a typical S&P
500 company. Chaparral
Steel Company is an example of a spin-off stock that was
bought out after we recommended buying the company. A $2,000
investment in Chaparral Steel Company grew to $15,305 in less
than two years.
Some spin-offs, frankly, look like ugly
ducklings. The spin-off's industry may be out of favor, the
company might not yet be profitable, or the business idea
is just too mundane to generate much interest. It's these
unloved spin-offs that often become the most profitable for
investors. After the company matures and starts showing up
in stock screening software and on Wall Street analyst's radar,
the management of the spin-off often has had time to make
business decisions that improve the company's bottom line,
and then investors start snapping up the stock which can send
the company's stock skyward. Marine
Products Corp. was an example of an ugly duckling that
ended up performing exceptionally well. A $2,000 investment
in Marine Products Corp. grew to $12,785 in three years.
Why The Superior Performance Of
Spin-offs Is Likely To Continue
Institutional investors drive the vast majority
of stock trading. Many of these pension funds and mutual funds
are unable to purchase spin-off stocks because spin-off stocks
are usually too small for an institutional portfolio or fall
outside of their area of focus. A mutual fund with a $185
billion portfolio that purchased a $500 million spin-off company
wouldn't see its fund performance budge, even if the spin-off
doubled in value. And that's assuming a mutual fund could
buy 100% of the spin-off's outstanding stock, which isn't
the case. Usually mutual funds are limited to purchasing 10%
of a company. In our scenario, 10% of the $500 million spin-off
means the fund would be limited to purchasing $50 million.
This may sound like a lot, but $50 million would be only 0.03%
of the mutual fund's portfolio. That makes the spin-off not
worth the mutual fund manager's time.
Furthermore, many institutional investors
are only allowed to purchase stocks in the S&P 500 index,
an index that includes only the largest companies in the country.
Most spin-offs don't initially start off in the S&P 500,
although many gain admission later after growing in size and
prominence.
To sum up, because the vast majority of
trading volume is done by institutional investors, the universe
of spin-off stocks is mostly left to the individual investor
to exploit. Not only are spin-offs likely to continue to significantly
outperform the rest of the stock market, they seem to be performing
even better lately, according to Barron's: "Since 2000,
spin-offs have beaten the S&P 500 by 45% while those done
since 1990 have topped the S&P 500 by 18%."
So while spin-off recommendations may be
difficult to obtain (our competitor at www.spinoffadvisors.com/research.htm
charges an outrageous $24,000 per year), our price
is much more reasonable.
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