“Spin-Off to Pay-Off: An Analytical Guide to Investing in Corporate Divestitures” by Joseph W. Cornell is one of the few books that discusses spin-offs and the benefits of investing in them. The book outlines a number of considerations when determining whether a spin-off is attractive or not, and when and how to best profit from these situations. Here are five things that I learnt from this excellent book:
1. Why Spin-offs Occur
Cornell believes that spin-offs can be “simplistically” thought of as falling in to two categories: high-quality and low-quality. A “better quality” spin-off is typically a business that is dissimilar from the parent company’s core business. These pure plays are typically more highly prized by investors, and these divisions can languish due to a lack of management attention and focus if the division is dissimilar to the parent.
“Low quality” spin-offs occur more frequently than high quality spin-offs. Cornell states that these spin-offs may present greater investment opportunities than high quality spin-offs, as they typically face significant problems and are frequently unprofitable. The parent company’s management may have lost patience with the division, and lack the ability or drive to deal with it.
The benefits of spinning off a low quality division may include enhancing the overall market value of the remaining operations.
2. Why Spin-offs prosper
Cornell spends a significant portion of the book outlining the performance benefits of spin-offs. In his view, the primary reason for the fact that spin-offs outperform is because independent managers have the freedom and incentives to pursue new ventures, reduce overheads and refocus the business. The new company also has access to new sources of capital to grow the business.
In my opinion, the primary reason that spin-offs outperform is that new management is correctly incentivised to improve the performance of the business. With the new management incentives based on the share price of the spin-off, a renewed focus and entrepreneurial environment places shareholders in alignment with management.
Lastly, Cornell states that many spin-offs are five times as likely to be acquired within several years versus other stand-alone companies. This alone would be reason enough to drive the market beating results of spin-offs.
3. Why Spin-offs are misvalued
There are a number of structural reasons why spin-offs are often misvalued following the transaction. The first, and most important, is the significant selling pressure seen by these companies following the divestiture of the new company. The selling pressure is almost entirely due to the actions of institutional investors.
Many portfolio managers are bound by strict investment guidelines as to what their portfolios can and cannot contain. Typical criteria include firm size, dividend yield and leverage ratios. A spin-off that doesn’t meet these criteria must be sold, regardless of any other investment merits. This results in a large amount of selling pressure, without any natural owners to take up the shares that are being sold. This can result in spin-offs trading below fair value.
Another source of selling are investors who are primarily interested in the parent company. When given ownership in a new entity (which can be unrelated to the parent company’s core business), investors typically sell without considering the investment merits of the new company. With spin-offs typically being a small proportion of the parent company, investors can also often be stuck with minuscule holdings. In many cases, investors will sell to simplify their portfolios, adding further selling pressure.
The factors outlined, combined with a lack of trading volume and small amount of institutional research, creates significant downward pressure on stock prices. The positive of all this downward pressure? It can create significant opportunities for astute investors.
4. Rules of thumb for evaluating spin-offs
Cornell provides five rules of thumb for evaluating spin-offs:
- Is the business similar to the parent’s core business?
- If the business is similar, there tends to be fewer investment opportunities, as the business is typically well understood and followed.
- Is the business dissimilar and much smaller?
- These types of spinoffs typically create investment opportunities.
- Are the dividend policies between the spin-off and parent different?
- As discussed above, differing dividend policies can cause forced selling. This is particularly the case when a parent company has an established dividend policy and the spin-off is intending to pay no dividend. Differing policies can create opportunities.
- Is the spin-off contained within the same investment index as the parent company?
- When the spin-off falls outside the index of the parent (for example, the ASX200 or S&P500), there is likely to be considerable forced selling by institutional investors. This can create investment opportunities.
- Spin-offs with high distribution ratios (for example, 1 spin-off share per 20 parent shares) creates “simplification” selling
- Investors will eliminate small and inconsequential shareholdings to simplify their portfolios, creating additional selling pressure.
5. The best time to invest in spin-offs
The three periods when investors can invest in spin-offs are the pre-spin period, the initial trading period and the seasoning period.
The pre-spin period is the period after which the spin-off is announced. This can be an attractive time to purchase a potential spin-off as the spin-off company may be undervalued, and the parent company may be undervalued due to the presence of the potential spin-off.
The initial trading period is the period in which the spin-off has listed, but selling pressures have not yet abated. The trick with purchasing here is to step in once the selling has begun to abate.
The “seasoning” period is the period in which the company first proposes the spin-off, and can last until the spin-off is actually enacted. It is different to the pre-spin period as the parent company at this stage has provided no details or timeframe other than the intention to eventually spin-off the division.
In my experience, investing in spin-offs has provided some of my largest investment success. This book helped me build out another option for identifying potential investments. Ay book which can provide a repeatable methodology for identifying attractive opportunities is one to be recommended, in my opinion. “Spin-off to Pay-off” provides an extremely worthwhile discussion of one of my favourite investment opportunities and I recommend it those looking to add another arrow to their quiver.