I immediately pricked up my ears last month when ITT (NYSE: ITT) and Marathon Oil (NYSE: MRO) announced that they would be spinning off some of their businesses (defense and water for ITT, refining and sales for Marathon). Spinoffs remain an underappreciated area in which the individual investor actually gains an edge over institutions. Let me tell you why -- and explain how you can seize that advantage.

Spinoffs are attractive for two main reasons:

  1. External: Non-economic selling. When a company spins off one of its units, institutional investors are rarely interested in holding onto the shares of the new company that they receive. The company being spun off is typically much smaller than the parent, and in a different industry. Additionally, if the new shares don't belong to indexes that contain the parent (overwhelmingly likely), index funds are mandated to sell them. None of these reasons relate to the company's quality or its intrinsic value, creating ideal conditions for a temporary disconnect between price and value.
  2. Internal: Improved governance. Once a business separates from its parent, its management's interests are much more tightly coupled with those of shareholders. As such, the company's historical results, presented in filings prior to the transaction, will often understate its true earnings power.

Guidelines for the spinoff investor
Both factors translate into practical guidelines for investing in spinoffs -- although neither excuses you from doing your own due diligence.

First, buy spinoffs at depressed prices as large investors dump their shares. In Institutional Demand and Security Price Pressure: The Case of Corporate Spinoffs (1993), the authors found that spinoffs performed poorly during their first 30 days of trading, but partially recouped that underperformance over the next 30 days. If these results still hold true, picking up shares a month after they begin trading should prove satisfactory.

Once you own them, you need to hold on to the shares long enough for the market to revalue them, thanks to improved results and/ or a new constituency of shareholders. According to a Penn State study, spinoffs' largest gains arrived in their second year, not the first.

Five high-quality spinoffs
The following table shows the relative returns of five spinoffs from the past five years. The pattern of underperformance in the first month is not clear in this sample, with three of the five spinoffs actually outperforming the index in the first month. However, there is but one exception to spinoffs' outperformance over the following two years: money-transfer gorilla Western Union (NYSE: WU):

Company

Return relative to S&P 500*, 1st month of trading

Subsequent 2-yr Return relative to S&P 500, Annualized

Brookfield Infrastructure Partners (NYSE: BIP)

(3.7%)

2.7%

Chipotle Mexican Grill (NYSE: CMG)

4.8%

46%

Western Union (NYSE: WU)

7.8%

(0.6%)

Kraft Foods (NYSE: KFT)

1.4%

6.9%

Philip Morris International (NYSE: PM)

(6%)

7.5%

Source: Capital IQ, a division of Standard & Poor's and Yahoo! Finance.
*On a price return basis.

All five companies are superior businesses that should continue to earn an economic return on shareholders' capital into the foreseeable future. Assuming that you don't pay an absurd price for shares (Chipotle looks a bit suspect here), you stand to earn satisfactory or even good returns. However, for your best chance of achieving great returns, invest in these stocks at a really attractive valuation.

The one that got away: Mead Johnson
I won't soon forget the spinoff I didn't invest in two years ago. In an email to three Foolish colleagues dated February 11, 2009, I wrote:

"You need to put Mead Johnson Nutrition on your personal watchlist. The world's largest producer of infant formula started trading today after being carved out of Bristol-Myers Squibb. This is a Buffett-type business..."

If only I had been smart enough to follow my own advice! The chart below, which shows Mead Johnson's performance relative to the S&P 500 since the spinoff, should give you a hint of my non-buyer's remorse (the blue line belongs to Mead Johnson, the green line is the S&P 500):

Mjnvssp

Source: Yahoo! Finance.

Since February 2009, the market has had a fantastic run. Yet Mead Johnson has managed to smash the market's returns, more than doubling in the process. At nearly 23 times consensus earnings for the next 12 months, some of those gains look borrowed from the future. I wouldn't buy shares today, but I certainly wish I had two years ago!

It's your move!
Spinoffs and other "special situations" (stocks exiting bankruptcy, recapitalizations, M&A, etc) create real opportunities for alert individuals who know when to act, and which to choose. If you'd like to find out more about putting this strategy to work in your portfolio, drop your name in the box below. In return, Tom Jacobs, an experienced special-situations investor who manages a real-money portfolio for Motley Fool Special Ops, will send you videos detailing three special situations he likes today, as well as a personal invitation to join Special Ops when it reopens this month.

Brookfield Infrastructure Partners and Western Union are Motley Fool Inside Valuepicks. Chipotle Mexican Grill is a Motley Fool Rule Breakers recommendation. Western Union is a Motley Fool Stock Advisor selection. Brookfield Infrastructure Partners and Philip Morris International are Motley Fool Global Gains picks. Brookfield Infrastructure Partners and Chipotle Mexican Grill are Motley Fool Hidden Gemsrecommendations. Motley Fool Options has recommended a write covered strangle position on Western Union. The Fool owns shares of Brookfield Infrastructure Partners P., Chipotle Mexican Grill, and Philip Morris International.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.