Upset the Market

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The quickest way for a team to get bounced out of the NCAA tournament is to underestimate an opponent.

So far, no No. 16 seed has beaten a No. 1 seed, though four No. 15 seeds have upset No. 2 seeds. We see most of the upsets from teams seeded 11, 12, and 13. In 2006, the story of the tournament has to be George Mason, the 11-seed that made it to the Final Four. I don't think anyone is underestimating them now.

Spinoffs beat the market
As investors, we don't want to get caught underestimating potential opportunities. In his book, You Can Be a Stock Market Genius, investor extraordinaire Joel Greenblatt laid out one type of opportunity the market often underestimates: spinoffs. As Greenblatt's 40% annualized returns since 1985 would indicate, he has been able to upset the market quite often during his career.

Why are spinoffs poised to beat the market? It's usually because following the spinoff, there is considerable selling pressure on the new company's stock. This pressure causes the stock price of the spinoff (and sometimes the parent company) to be mispriced, giving observant value investors a chance to scoop up a bargain before the market realizes its mistake. And the funny thing is, investors underestimate the potential for spinoffs time and time again.

Two examples
In May 2004, GE spun out insurance and investment services provider GenworthFinancial (NYSE: GNW) to shareholders in an IPO for $19.50. Since this was considered a slow-growth business -- and at more than 100 years old, it was certainly mature -- one had to wonder how the IPO would be accepted. The market, getting a deeper look into Genworth's financials, seems to have liked what it saw: Shares have risen to $33.75 as of this morning.

In July 2004, Motorola (NYSE: MOT) spun off its semiconductor manufacturing business to shareholders. FreescaleSemiconductor (NYSE: FSL), which makes embedded semiconductors that go into automotive controls, cellular phones, PDAs, and computer networking equipment, started trading at $14.02 and received lots of negative press on the way to becoming a publicly traded company. In the Motorola fold, Freescale lost lots of money. But under the scrutiny of the stock market, it has become a profitable, cash-generating company as margins have expanded. As a result, the shares currently trade at $27.73.

Admittedly, Freescale Semiconductor was never on my screen as a potential investment. But Genworth certainly was; I was a GE employee at the time. Yes, you guessed it -- I overlooked that opportunity.

An upset in the making?
Recently, Cypress Semiconductor (NYSE: CY) spun off its solar energy cell and equipment business, SunPower (Nasdaq: SPWR). At a time when cleaner alternative forms of energy are becoming increasingly important, it's easy to see why SunPower shares have generated excitement.

But according to a Barron's article last week ("Top Spins" by Andrew Bary), the market may be up to its funny old tricks again.

A little bit of history should put the Cypress/SunPower story in perspective.

3Com spun out Palm (Nasdaq: PALM) in March 2000. Then, the market did something interesting: It valued 3Com at less than its stake in Palm. In a very famous article, "Can the Market Add and Subtract?" (link goes to a pdf file), behavioral finance specialists Owen Lamont and Richard Thaler showed the market was having some trouble with third-grade math. On the first day of trading, Palm closed at $95.06, implying that 3Com should have been valued at $142 (1.5 times greater than Palm's price based on the ownership structure). Instead, 3Com's share price dropped to $81.81. Hence, the market gave negative equity value to 3Com based on its ownership of Palm.

As was written in the Barron's article, Cypress traded at $17 per share as of March 10, 2006. Its stake in SunPower is about $14 per share, leaving the rest of Cypress' business valued at $3 per share. So is this an upset in the making, where the market will revalue Cypress' shares upward? It could be, but only if the shares of SunPower aren't overvalued at $38.

The Foolish bottom line
While spinoffs by no means guarantee an upset, they have certain characteristics that increase the probability of market-beating returns.

The Motley Fool Inside Value newsletter service thinks it's found a spinoff opportunity that could beat the market. LibertyMedia carved out Discovery Holding (Nasdaq: DISCa), owner of The Discovery Channel and other cable franchises, in 2005. To see why Discovery Holding and the other recommendations have a great chance of beating the market over the long run, please accept this 30-day guest pass as a gift from the Inside Value team. You'll have complete access to all of the recommendations as well as lots of information that can help you be a better investor.

Fool David Meier owns shares of General Electric, but no other company mentioned in this article. Palm is a Motley Fool Stock Advisor recommendation. The Motley Fool has a disclosure policy.