Key Questions: Why Would My Portfolio Benefit From Taking a Spin Class?
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Smart investors can benefit when a company divests itself of assets that may no longer make sense for it to own; but be careful.
What is a Spin-Off?
A spin-off refers to a corporate event in which a company creates a separate independent company from its existing business and subsequently distributes the shares of the new company to existing shareholders. Once the spin-off occurs, shareholders are free to sell or hold the shares of the newly formed publicly traded entity. These spin-offs can create opportunities for careful Investors.
Why Do Companies Undergo Spin-Off Transactions?
A good practice for most corporations is to periodically conduct a strategic review of the portfolios of their business units. Through this review process, a company may identify a business segment that no longer makes sense to own. Those reasons include a lack of synergies with other divisions, differing growth rates among various segments and the belief that investors are not valuing certain businesses correctly.
The next decision is whether to sell the business outright to a financial or strategic buyer or to spin it off into its own publicly traded entity.
The benefit of an outright sale is that the value created is more certain once a purchase price is agreed upon. Spin-offs, on the other hand, get favorable tax treatment under Section 355 of the Internal Revenue Code.
Per this regulation, shareholders do not have to pay tax on the newly distributed shares and the parent company does not have to pay any taxes, either. If the parent company has owned the business it wants to spin off for a long time, it likely would have a high tax bill at the sale, making the decision of whether to spin off or to sell that much easier.
Why Do Spin-Offs on Average Outperform the Market?
The Bloomberg Spin Index has outperformed the S&P 500 Total Return Index by 1.5% per year over the past 20 years. One of Charlie Munger’s (Warren Buffet’s right-hand man) top three pieces of investment advice is to “carefully study spin-offs.” With this type of long-term track record of outperformance, we tend to agree.
Over our careers, we have observed several reasons why spin-offs have outperformed and why, in our view, this outperformance can be sustained. Among them:
- When a company is spun out of a larger company, the smaller company often lands in the hands of investors who are hired to own shares of large companies. Thus, when these investors receive the shares of the smaller company, they sell their shares en masse merely because the spin-off company does not fit their assigned investment mandate. This indiscriminate selling can create a temporary but significant mispricing or market inefficiency between the intrinsic value of the company and where the stock is trading, creating opportunities for investors who may be more patient and discerning.
- Spin-offs are commonly under-appreciated (and perhaps under-managed) within a larger company. Once they are spun off, however, the new companies can be accompanied by more focused management teams motivated to drive stronger growth and/or margin performance.
- Many spin-offs ultimately are acquired at a premium to compensate existing shareholders for future returns that they may forgo by agreeing to allow the business to be sold. To preserve the tax-free status of the spin-off as noted earlier, shares of a spin-off must stand alone for two years. After that, they are generally free to be sold to the highest bidder.
Spin-offs are not without risks, which is why we place emphasis on the word “carefully” in Munger’s quote. Sometimes a company wants to spin off a business because it has a challenging growth outlook or to cordon off a legal liability from the larger entity. The company can also use a spin-off to improve its balance sheet while leaving the spin-off with a suffocating amount of debt.
Additionally, given the historical outperformance of spin-offs, more investors may be analyzing spin-offs than in the past. When an area of the market garners more focus from investors, the additional competition may make this part of the market more efficient, potentially lowering future returns.
It is difficult to consistently outperform the market over a long period of time. We believe that investors can improve their odds of success by looking for investment ideas that others neglect. We also believe that as dedicated equity research analysts we can add value by analyzing orphaned stocks, a luxury of having a true long-term investment orientation.
If we can discover an opportunity by identifying ideas differently than the consensus, we will consider adding them to client portfolios, knowing that spin-offs are an area of the market that gives us better odds of finding stocks that will drive outperformance. Please reach out to your advisor and ask how spin-offs are being incorporated into your portfolios today.
For more information, please contact your advisor.
About Connor Cloetingh
Connor Cloetingh is a Senior Lead Research Analyst responsible for the Materials and Healthcare sectors within the Equity and Fixed Income Research team. Connor has 7 years of experience in Equity Research, most recently on the buy side at Ancora Advisors as a generalist equity analyst on the $1.5 billion AUM Ancora/Thelen small and mid cap funds. Prior to joining Ancora, Connor was a Sr. Equity Research Associate at KeyBanc Capital Markets covering the Chemicals industry. He began his investment career at Northcoast Research covering the medical device and healthcare distribution industries. Connor holds a Bachelor of Arts in Finance with a Minor in Economics from Michigan State University and is currently studying for an MBA at the University of Michigan’s Ross School of Business.