Will These Stocks Really Earn Top Returns?

They say one person's trash is another person's treasure. If the same holds true for companies divesting themselves of unwanted businesses, investors might want to look to corporate spinoffs for profitable opportunities.

The ebb and flow of corporate scope
Over time, many companies see the scope of their businesses go through a cycle of expansion and contraction. A specialized company may expand its business into a related area, either by purchasing a competitor or building a new presence from scratch. Some companies even become conglomerates, expanding into areas that aren't closely related to their core business. As companies mature, their expanded scope can end up covering a huge swath of different industries and functions.

On the other hand, some companies decide that they no longer wish to keep doing business in certain areas, choosing instead to focus on what they consider their core operations. In such situations, a company has several choices. It can simply terminate the unwanted business, which might make sense if it's a big money-loser. But more often, a company will seek either to sell the unwanted business to an interested third party, or to place it in a separate corporate entity and distribute its shares to the company's shareholders.

How spinoffs help companies and investors
This last option, known as a spinoff, gives investors the chance to choose what they want to invest in. For instance, 10 years ago, Altria Group (NYSE:MO) was a huge conglomerate that included tobacco and food production around the world. Yet it also faced huge potential exposure from tobacco litigation, which threatened the entire business.

To mitigate that risk and insulate its other businesses, Altria chose to do two spinoffs: one of its Kraft Foods (NYSE:KFT) division, and another that included its operations outside the U.S., which are currently held by Philip Morris International (NYSE:PM). Altria shareholders received shares of Kraft and Philip Morris International, and they could choose to keep all three, or to sell the shares that didn't interest them in favor of focusing wholly on a particular part of the business. All three companies have held up better than the overall market in recent years.

Seeking spinoff profits
If you want to invest in spinoffs, one ETF makes it easy. The Claymore/Beacon Spinoff Fund (CSD) invests in an index of stocks that have been spun off within the last two years. Right now, the fund holds between 30 and 35 stocks.

Judging from the recent performance of some of its top holdings, the Claymore ETF certainly appears to be a promising investment. Here's a sample:

Source: Morningstar.

All told, the fund has posted a return of more than 50% so far this year.

Unfortunately, though, this year's gains came only after big losses during 2008. Last year, the Claymore ETF lost a whopping 55% of its value, underperforming the S&P 500 by double-digit percentage points. Since the fund has only existed since late 2006, its terrible 2008 will haunt the fund's track record for years to come. Shareholders apparently agree, since the ETF has only $8.8 million in assets under management.

The pros and cons of spinoffs
You shouldn't draw any definite conclusions from the Claymore ETF's mixed experience, however. Just like any investment, some spinoffs will be attractive investments, while others won't. Moreover, you may wish to hold spun-off companies longer than the two-year time limit that Claymore's investment restrictions impose.

One thing to look for in a prospective spinoff is a motivated set of corporate managers, who will thrive on the newfound freedom they'll get when their business becomes an independent entity. In contrast, companies that relied heavily on their internal relationships may not do as well when they're forced to stand on their own.

Focusing on spinoffs isn't an automatic moneymaker. But if you choose spinoffs that offer attractive opportunities at reasonable valuations, then the odds are good that you'll do quite well.