In Part 1 of this introduction, we went through why spinoffs happen, and how, thanks to the way spinoffs are structured, you can pick up shares of spun-off companies cheaply. In Part 2, we'll explain how you can find the best spinoff investments.
Foolish spinoff investing
Knowing that spinoffs generally beat the market, and that it's possible to buy them at great prices after everybody else sells, you could simply buy a basket of spinoffs and expect something close to that historical average return of 10 percentage points more than the market.
But as Fools, we're picky. We know that with a little more work, our returns can be even better. Take Chipotle
We want to pick out the best spinoff investments out there. To help us stack them up, we ask four key questions.
1. Do institutions want to own the spinoff?
The less that institutions want the spinoff, the better, for us. Anything that provokes Greenblatt's "indiscriminant selling" creates a better opportunity for us. Spinoffs that are small, debt-laden, in unloved industries, not in the S&P 500 or other major indexes, in a business unrelated to the parent, or in a different country than the parent -- any of those characteristics or similar ones can get us excited.
2. Do insiders want to own the spinoff?
We want to see institutions abandoning the spinoff stock, but we want insiders grabbing as many of those shares as they can get their hands on. If the transaction is structured to land shares in the hands of the management team of the spinoff, that makes us more comfortable. And if insiders are buying shares of the spinoff on the open-market (perhaps directly from the selling institutions), that makes us confident that management knows something about the value of the spinoff company that the market doesn't.
3. Does management have incentives to make the spinoff succeed?
This is a big one. We want managers whose compensation depends heavily on the spinoff company's success. Like the second criteria, we want them to own a nice chunk of stock, and we also want as much of their compensation to come in the form of stock and options as possible. The managers are in the best position to help the spinoff to succeed, and we want them to be as motivated as possible to do so.
4. Does the spinoff transaction expose a "special opportunity?"
Sometimes, a spinoff creates a unique investment opportunity. It might open up a previously nonexistent possibility to invest directly in a great or deeply undervalued business. Perhaps we find ourselves offered an exceptional risk-reward situation. In any spinoff, we're looking for any special situation that the transaction creates.
The Spinoff Report Card
The Spinoff Report Card grades spinoffs and spinoff parents on each of these four questions and assigns a letter grade for each criteria as well as an overall grade. Keep a look out for this and other new Report Cards rolling out on Fool.com.
Enjoy the Spinoff Report Card series, and happy spinoff-hunting!
This is Part 2 of your guide to the Spinoff Report Card. If you haven't already, be sure to also check out Part 1: Why Spinoffs Beat the Market.
Fool analyst Alex Pape does not own shares in any company mentioned. The Fool owns shares of Chipotle Mexican Grill, which is a Motley Fool Rule Breakers selection and a Motley Fool Hidden Gems pick. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.