Many investors take it as an absolute truth that high returns necessitate high risk -- but it simply isn't so.

The whole premise of value investing is mispricing -- and the resounding success of legendary value investors such as Ben Graham, Warren Buffett, and Joel Greenblatt has shown that the market is often irrational, leaving gaping-wide opportunities for us to score massive gains without a commensurate level of risk.

A master of such investing, Joel Greenblatt achieved a gross annual return of some 50% in his Gotham Capital fund over a decade. Said another way, he generated a cumulative return of 5,200% compared with a 154% return for the S&P 500. Amazing.

How did he find the buried treasure?
One of Greenblatt's trademark strategies was looking to "special situations" -- like mergers and spinoffs -- for mispriced stocks with superior return potential. According to a study by Lehman Brothers, 88% of spinoffs between 2000 and 2005 outperformed the S&P by an average of 45% in their first two years as stand-alone businesses.

Why are spinoffs so successful?

  • The two businesses were unrelated. Often conglomerates are priced less than the stand-alone value of the individual businesses they comprise, so a spinoff offers the market the opportunity to more accurately price the businesses.
  • Poorly performing businesses may be separated from a parent. Without the albatross of a money-losing business around its neck, a solidly profitable parent company can become more attractive to investors, raising its stock price.
  • A hard-to-sell business can be spun to shareholders. An unattractive but fundamentally sound business might be hard to sell. In addition, the parent might load the spinoff with debt, improving the parent's financials in the process.

Even though spinoffs are successful, they tend to be mispriced because their shareholders don't want their shares. Their primary shareholders tend to be individual and institutional investors in the parent company, who usually receive a limited number of shares in the spinoff. Because their interest was primarily in the parent company (and because structural realities like size prevent institutional investors from keeping shares), they often sell the spinoff regardless of value.

Because such inefficiencies are built into the system, spinoffs continue to offer fertile ground for those looking for buried treasure.

A case study
Here are just a few high-profile spinoffs from the last 15 years.

Parent

Spinoff

Spinoff's Return

Date of Transaction

PepsiCo (NYSE: PEP)

Yum! Brands (NYSE: YUM)

656%

September 1997

Altria (NYSE: MO)

Kraft (NYSE: KFT)

36%

June 2001

Sara Lee (NYSE: SLE)

Coach (NYSE: COH)

2,175%

October 2000

Cablevision (NYSE: CVC)

Madison Square Garden

20%

January 2010

Source: Yahoo! Finance, as of Feb. 16, 2010.

With PepsiCo's exit from the restaurant business, it homed in on its drinks and snacks business. Altria's spinoff allowed investors to separate the risk of tobacco litigation from Kraft's solid consumer brands. Sara Lee is still a bit of a conglomerate, but its spinoff of Coach years ago allowed that business to flourish. And Sara Lee is on track to spin off another business soon, as is Cablevision, which is prepping its Rainbow Media unit for the public market, following its successful transaction with Madison Square Garden.

Although spinoffs of large companies like these can be profitable, you're much more likely to find explosive returns in spinoffs of little-understood small caps, especially if they come from a huge parent such as Altria or PepsiCo. Sara Lee's spinoff of the small-cap Coach -- with its 2,175% return in just a decade -- is the poster child here. Spinoffs allow both companies to focus on their operations and allow investors to more accurately value each business.

The importance of small-cap spinoffs is illustrated by one of Greenblatt's biggest successes: Marriott.

To optimize its operations, Marriott had decided to split itself into two separate businesses: Host Marriott, to own its properties, and Marriott International, to manage those properties. The second business was highly desirable because of its lucrative and asset-light management business. The first business was the ugly stepchild -- it owned low-growth properties and was loaded with billions in debt before it was set free. Which of these companies was the value?

After some due diligence, Greenblatt decided to invest in Host Marriott. He was particularly keen on the supposed unattractiveness of the business, the fact that key insiders in Host were incentivized to make the company succeed, and that Host was highly leveraged, since debt would magnify returns if the company were successful.

Within four months of being spun off, Host Marriott ended up nearly tripling.

Come dig with us
While some lucrative spinoffs are high-profile, there are many more under-the-radar stocks that offer even better opportunities. If special situations and deep value opportunities intrigue you, then take your investing to the next level in 2011 with
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Jim Royal, Ph.D., does not own shares of any company mentioned. Coach is a Stock Advisor selection. PepsiCo is an Income Investor selection. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Altria, Coach, Madison Square Garden, and Yum! Brands. The Fool has a disclosure policy.