Digging for Gold in the Spinoff Market

Let's face it: Most CEOs don't have the smallest of egos.

It shouldn't surprise anyone that management can get a little carried away with the whole master-of-the-universe thing. The private jets, the penthouse suites, the beaming portraits on the front covers of annual reports -- it's easy to see why executives might believe in their Midas touch so much that they take on projects far beyond their competence.

Even smart managers have been known to acquire companies that bear no resemblance to their parent company's business model. When food companies like Sara Lee (NYSE: SLE  ) take on shoe-polish, underwear, and shower-gel companies, or an online retailer like eBay (Nasdaq: EBAY  ) goes after a telephone company like Skype, investors are often left scrambling to make sense of the post-merger hodgepodge.  

When combinations don't end up working out, companies often send subsidiaries packing by spinning them off to shareholders. As a shareholder, it can be easy to view these spinoffs as corporate garbage. After all, if the CEO of this company doesn't want anything to do with it, why should you? It's likely you're only interested in the original company, and now you're suddenly handed a few shares of some orphan company you may never have heard of. If you're like most people, rather than researching the new company and judging its potential, you simply sell it and move on. Talk about a rough welcome mat.

The result: Spinoffs are frequently overlooked as nothing more than the unloved spare parts of a bloated business. It isn't exactly love at first sight.

Free as a bird, and ready to fly
But just as some of the best investments can be found where others aren't looking, you may benefit from looking over -- rather than overlooking -- both the spinoffs and the parent companies that get rid of them. As the old adage goes, "Marriage is about love; divorce is about money." A study performed by Penn State looking back over 25 years found that over the three years following a breakup, spinoffs outperformed the market by more than 10% a year, and their parent companies beat the market by 6% a year. Perhaps the Midas touch of CEOs works better in reverse.

Here are some factors to look for that can contribute to spinoff greatness:

  • Being freed from the chains. Sometimes a company will choose to shed a subsidiary if the two businesses are holding each other back. In business, sometimes you're only as strong as your weakest link. For example, McDonald's (NYSE: MCD  ) spun off its wildly popular burrito joint Chipotle (NYSE: CMG  ) (NYSE: CMG-B  )  in 2006 to make it independent of McDonald's slower growth. Since being spun off, Chipotle stock has nearly tripled in value. Altria (NYSE: MO  ) plans on spinning off its international cigarette business sometime next year, freeing it from the company's U.S. litigation nightmare.
  • Management can't get enough of it. Spinoffs focus management's efforts more narrowly. Rather than an indirect interest through the parent company, the spinoff's management now has a direct interest, often in lucrative stock options. Insider ownership gives management incentives they've never had before to make sure that shares of their company does well. Pay close attention to inside ownership in spinoffs - the more incentive management has, the better you're likely to do.
  • Some big investors can't own it. Some pension funds and mutual funds have their hands tied when it comes to what they can own. Some can own only stocks that fall into a certain sector, or stocks that belong only to a certain index, like the S&P 500 average. When a spinoff comes along that doesn't fit certain criteria, they can be forced to sell -- and often times en masse. When telephone behemoth AT&T (NYSE: T  ) was forced to break itself up into smaller companies, some of the newly formed "baby bells" were too small for mutual funds to own, so they ended up chucking them. This indiscriminate selling can artificially send shares falling, giving investors the opportunity to jump aboard at cheap prices.

It's important to keep in mind that spinoffs take place for a reason: to create shareholder value. Thankfully, no alimony is required for these divorces. Whether it's finding a newly relieved spinoff, or jumping into a leaner and meaner parent company, breakups can provide lucrative opportunities to investors who can see the forest through the trees.

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