Companies undertaking spinoffs are among the least-followed potentially lucrative investments available. Often it's the company being spun off that appears to be an ugly duckling, but is actually the attractive investment opportunity. Other times it's the parent doing the spinning that has the appeal, and sometimes both companies can be more attractive after such an action.

Spinoffs come to the market as tax-free distributions to existing shareholders of a parent company or as an IPO by the parent company. There are also situations where a parent will IPO one of its businesses and then later spin off the remainder to shareholders. This is what Hidden Gems selection Walter Industries (NYSE:WLT) did with Mueller Water (NYSE:MWA).

These four criteria can hint at an attractive spinoff:

  • Unattractive factor. Something unattractive is a plus. Too small, too obscure, or too different from the parent -- something that makes investors want to sell. Sometimes it's because investors are only interested in owning the parent; other times, it is because institutional investors have strategies that don't allow for holding companies below a certain size or outside of their area of focus. The end result of their disinterest is to sell, which can temporarily depress the price of even a very good business. For this reason, you want to closely track a spinoff in the first few weeks after it begins trading. But when it really gets interesting is when the spinoff has one of the following traits as well.
  • Growth. Some spinoffs are simply freeing a growth business to shine. The beauty of these spinoffs is often that they are free of the parent's capital allocation decisions. Once spun off, the growth business is free to retain the cash flow it generates and plow it back into the growth opportunities it sees. This was part of the strategy behind Sara Lee spinning off Coach (NYSE:COH) a number of years ago.
  • Leverage. Parent companies often use their spun-off children as a way to unload debt. It's somewhat counterintuitive, but a spinoff that is saddled with debt can be a very good investment, because that leverage amplifies the impact of sales growth and margin improvement, promoting debt repayments and lowering future interest expenses. Debt also unquestionably makes the spinoff a riskier investment, because if sales or margins fall, the interest payments get tougher to cover. Hanesbrands (NYSE:HBI), another company sprung from Sara Lee, fits this mold with $2.5 billion in debt and a sliver of equity.
  • Incentives. To catch this one, you have to be paying attention to the prospectus and filings of a spinoff. Many times, management has plenty of incentives in place to make sure the stock price of a spinoff performs. This can be an ownership stake, options, restricted stock, or stock appreciation rights. Just because incentives are in place doesn't mean a spinoff will be successful, but it increases the odds that management will be keen to decrease costs and take other actions that increase shareholder value.

Some upcoming spinoffs to keep an eye on
There are a number of companies in the process of being spun off. Perhaps the best known is the remainder of Kraft being spun off from Altria (NYSE:MO). A couple of other notable ones include Automatic Data Processing (NYSE:ADP) spinning off its brokerage operations and Morgan Stanley (NYSE:MS) spinning off its Discover credit card business. Cadbury-Schweppes has also announced it will split itself in two. If you track the news closely, you'll find that there are even more spinoffs in the works. A quick search through my news alerts yields more spinoffs happening than I have time to focus on.

Foolish final thoughts
As a final word, I'd recommend not forgetting about the parent companies. Many times the parent company in a spinoff also benefits from being to focus on just its core operations and is able to more efficiently allocate capital.

If you're excited about spinoffs and want to start digging into them and other special situations, I highly recommend getting a copy of You Can Be A Stock Market Genius by Joel Greenblatt. It's not a great title for a book, but within its pages is a treasure trove of valuable case studies and insights on spinoffs and other special situations. After that, be prepared to pay close attention to the news and be ready to dig through filings with the SEC, because to get to the best spinoff opportunities, you have to have a grasp on the details of the transaction. If more than one of the traits outlined above really stands out, you could have a winning investment idea on your hands.

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Bill Mann loves a good special situation. That's why he recommended Walter Industries in The Motley Fool's Hidden Gems newsletter and got Mueller Water along the way. To see what other ones he's found, simply sign up today for your free 30-day trial.

At the time of publication, Nathan Parmelee owned shares in Mueller Water and Walter Industries. He had no financial interest in any of the companies mentioned. Kraft is a current Motley Fool Income Investor recommendation, while Sara Lee is a former selection of this newsletter. The Fool has a disclosure policy.