The Right Track on Tracking Stocks

By Bill Mann (TMF Otter)
March 6, 2000

Have you noticed how many tracking stocks have come to market lately? It seems that companies can't resist the benefits of having some of their higher-growth or higher-profile divisions being evaluated on their own. And investors have responded, with some of the highest-flying securities around coming in the form of tracking stocks. By separating out these divisions, the companies have attracted massive attention from investors interested in the growth portions of their businesses, but not the stodgier, slower-moving components.

Tracking stocks differ greatly from normal issues, and they have their own inherent risks. In offering this special feature, The Motley Fool hopes that investors will be able to make decisions about investing in tracking stocks based on a knowledge of all their strengths as well as their weaknesses.

High-Profile Tracking Stocks

Tracking                   Parent      Date     Total 
Division        Ticker     Company    Issued    Return
Liberty Media   LMG.A        AT&T      1995*     1037%
Sprint PCS       PCS        Sprint     1999       337%
DLJDirect        DIR         DLJ       1999       -69%
Hughes Elec.     GMH          GM       1991      1206%
ZDNet            ZDZ      Ziff-Davis   1999       -11%
Clearly, some tracking stocks have done quite well. And Wall Street has certainly noticed. As such, we see more and more companies being rumored to issue these designer stocks. But what are tracking stocks, really?

The honest answer is that there is a slightly different flavor for each one that is issued. Generally, though, a tracking stock is a way for a company to divide out certain components of its business, thus permitting investors to receive the dividends based upon the performance only of that division. On one hand, the investor is taking on a much higher risk by disassociating her returns from all but one of the company's operations -- in other words, limiting the breadth of the industry covered by the investment. But the argument for tracking stocks is that investors are willing to take on the added risk in order to gain larger returns than they would have been able to achieve by investing in the company as a whole.

But whether you are investing in tracking stocks or not, it is possible that one of your current investments may be affected. Why? When a company issues the tracking stock, the remainder of the company will remove that portion of its operations from its balance sheet. This could have the unintended effect of showing a weakness that was otherwise hidden when the balance sheet was consolidated.

But the attractiveness of tracking stocks to corporations may prove irresistible. For starters, the company gets a high-profile event that generates a great deal of excitement around the company. Then, as the tracking stock goes through something akin to an initial public offering (IPO), the parent company has the opportunity to add a considerable cash windfall to its coffers as a result of the "sale" of its component to the public. But most importantly, as opposed to an outright spin-off, the parent company retains control of a tracking company since the board of directors for the parent will continue to lord over the child.

Just as importantly in the current business environment, an "IPO" of a tracking stock has the benefit of rewarding and keeping managerial talent. This has proven more and more difficult for the old-line companies, as employees see a relatively humdrum stock performance as compared to the explosive growth and liberal stock option grants at higher-growth companies. As human capital becomes more crucial to the long-term success of a company (some would call human capital the latest commodity in the business cycle, more important even than financial capital), issuance of options for a high-growth tracking stock to employees becomes a viable incentive to keep them from jumping over to competitors in the dotcom realm.

So this is an all-around good thing, right? Well, maybe not. For one, the tracking stock is very different from an independent subsidiary. As such, should there be a conflict of interest between the tracked division and the parent company, the board of directors would have fiduciary responsibility to the parent first. This makes the tracking stock quite vulnerable. The best example of this was the first tracking stock, EDS (NYSE: EDS), which was issued in 1984 by General Motors (NYSE: GM) when the company realized that its information systems division was grossly undervalued by the market. Since EDS was still part of GM, it had access to GM's credit lines, but at the same time didn't have its performance tied to things like Oldsmobile.

The good times did not last, and things got messy at GM; the EDS stockholders felt that their interests were subsumed to those of the larger company, which, by design, they were. The shareholders felt that GM mismanaged EDS assets, letting the gains from EDS offset operating losses at other parts of GM. EDS ended up being spun off entirely.

Some financial pundits believe that tracking stocks are a disaster waiting to happen, as the burden on directors to balance the competing interests may be too great in the long term, particularly in a period of lower economic returns. There's no way for us to know in advance, but the EDS scenario paints a bad example of how things can go wrong when a tracking stock is in conflict with its parent. Still, Sprint (NYSE: FON) may have it right, as they have assigned a separate special committee chaired by an outside director specifically to represent the interests of Sprint PCS (NYSE: PCS) on the larger company's board.

This may be the bridge between a well-designed and a poorly designed tracking stock. If individual investors can gain some assurance that there is someone on the board specifically charged with looking after their interests, then the tracking stock can provide a legitimate way to participate in the high-growth portions of some of the best businesses in America.

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