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The quickest payday that investors typically ever get is when a stock they own receives a takeover bid from a potential acquirer. But there's a more subtle way that some companies can unlock hidden shareholder value, and even as merger and acquisition activity picks up, more companies are starting to turn to this smart alternative as a way of keeping shareholders satisfied.
Moving in the right direction
One of the most fascinating things about investing is the way that companies evolve over time. On one hand, some investors like companies to grow as big as possible, grabbing up acquisition candidates and forming industry leaders that dominate their respective spaces. A big merger can create economies of scale, reducing costs and allowing formerly separate groups of workers to find areas of shared talent that can produce greater results than either entity could have alone.
But at other times, the trend seems to be in the opposite direction. Big conglomerates can sometimes have difficulty focusing their efforts on one particular strategy, and so individual business units can languish behind a corporate bureaucracy that doesn't have the ability to identify a strong direction for the company as a whole. In that environment, a spinoff that separates portions of a company into separate and independent businesses can be the best move a company can make, both for shareholders and for the overall success of the businesses involved.
The scoop on spinoffs
The way spinoffs work is simple. Shareholders receive new shares of the spun-off entity. They can then decide whether to hold onto all their shares or keep only the stocks of the parts of the company that interest them most.
As businesses start to plan for a possible acceleration of the recovery, spinoff activity is starting to pick up. Yesterday, for instance, Fortune Brands announced that it would split up three separate business lines -- liquor, golf, and home products. The move would likely involve one or two spinoffs. Similarly, ArcelorMittal announced a spinoff of its stainless steel division, with the expectation that doing so could spur consolidation in the sub-industry.
But there are many reasons why spinoffs can make sense. In the case of Altria Group (NYSE: MO ) , splitting off its food business into Kraft Foods (NYSE: KFT ) and its international tobacco business to Philip Morris International (NYSE: PM ) helped insulate those units from any legal liability resulting from Altria's U.S. tobacco business.
In other cases, spinoffs can help free a promising business from a slower-growth company. Sara Lee (NYSE: SLE ) , for instance, has seen its stock go nowhere over the past decade. But investors who hung onto their spunoff shares of Coach (NYSE: COH ) have seen their shares rise 18-fold since 2000, translating to a 33% annual return over that period.
Of course, not every spinoff works. Take Shanda Interactive (Nasdaq: SNDA ) as an example. Last year, it spun off its online gaming unit into Shanda Games (Nasdaq: GAME ) . Although some believed that the spinoff would leave the remaining business with little or no value, it has turned out that while Shanda Interactive has found some growth from its offline businesses, Shanda Games is struggling and has fallen out of the top tier of Chinese Internet-based investing plays.
When a company announces that it's considering a spinoff, don't take it as an automatic excuse to bid up its shares. In some cases, the move will help the company deal with inefficiencies in the way the market is valuing its shares, resulting in more value for you as an investor.
But the more important long-term question is whether the businesses are better off together or apart. If a company breaks itself into pieces just to earn a quick windfall, it may sabotage its future success. By taking a close look at every aspect of the businesses and assessing their prospects as independent entities, you can drill down on whether the spinoff is likely to succeed -- and if so, which pieces of the post-split business will interest you the most. Doing that successfully could make you rich.
Spinoffs are just one way to make money with stocks. Click here to get The Motley Fool's free report, 5 Stocks the Motley Fool Owns ... and You Should, Too.