Joel Greenblatt needs no introduction. The professor turned hedge fund manager made a name for himself after achieving an annualized return of over 40% from 1985 to 2006. While most value investors are familiar with his “magic formula investing” strategy, less are familiar with one of his favorite asset classes known as “Spinoffs.”
In his book “You Can Be A Stock Market Genius,” Greenblatt describes a spinoff as the process in which “A corporation takes a subsidiary, division or part of its business and separates it from the parent company by creating a new, independent, freestanding company.” When analyzing a Spinoff, the corporation parting with the subsidiary, division or business unit is referred to as the “Parent” while the spun-off subsidiary, division or business is referred to as the “Spinoff.” Spinoffs create interesting investment opportunities and are just as prevalent today as when Greenblatt was managing his Gotham Fund.
According to a study by Deloitte and The Edge, since January of 2000, the worldwide asset class of Spinoffs has generated over 10x times the average gains of the MSCI World Index during their first 12 months independent of the parent.
The study also found when a parent company takes longer than six months to prepare, an average 50% greater return is produced after one year for the spinoff.
Greenblatt isn’t the only value investor who looks for opportunities in spinoffs. According to Mohnish Pabrai, when he and Gary Spier paid to have lunch with Warren Buffett and Charlie Munger, one of the three pieces of notable advice Munger mentioned was “carefully study spinoffs.” The fact that Munger took time to single out a specific type of investment opportunity is enough to make any investor take note.
What Is A Spinoff?
The mechanics of a Spinoff are simple to understand. When a Spinoff takes place, you as the investor are given an underlying position in the new company. The board of directors sets an exit date (similar to a dividend), and all active shareholders on record as of that date receive shares.
Before venturing further into the world of Spinoffs, it’s important to understand why a Parent company would choose to execute a Spinoff.
Why Do Spinoffs Occur?
At a starting point, a Spinoff can provide a vehicle for clarity. It is not uncommon for businesses to start, acquire, or combine operations that would put the business operating away from its core competency. As the diversified operating unit grows and contributes more to the overall performance of the company, it becomes more difficult for markets to place a value on the core business model. These unrelated businesses operating under the same company muddy transparency and often result in markets undervaluing the true potential of the separate units (commonly referred to as the asymmetric information hypothesis). Spinning off a division creates a wholly related entity that can be better understood and valued by markets (true for both the Parent and the Spinoff).
Another situation that warrants a Spinoff is the possibility that a good business needs to be separated from a not so great business. It is not uncommon to have divisions or subsidiaries that are unfortunately being held back as a result of operating under the umbrella of the parent company. It is also not uncommon to find a division or subsidiary that is dragging down the parent company. Either way, a spinoff can create an opportunity for good businesses to separate from bad businesses and operate on their own.
Realizing value is the primary driver behind Spinoffs. Different businesses are valued differently. When management feels the market is assigning a valuation method to the entire business that is unfair towards a division, a Spinoff becomes an appropriate solution. For example, if an oil and gas company creates a technology division to serve its units, it might reach a point where that technology division is a substantial business on its own. Spinning off the technology division would ensure its earnings are not grouped into the same valuation method as the core business of oil and gas.
A fourth reason that spinoffs come into play is the legalities around taxes. Without going into too much detail, spinoffs in most countries are performed as a tax-free transaction. Similarly, a spinoff can be staged via a tactic referred to as a Morris Trust Transaction to assist with an acquisition strategy. A Morris Trust Transaction is when a regular tax-free spinoff is completed followed immediately by a pre-arranged tax-free acquisition (typically by a strategic buyer).
Finally one of the last main reasons a company would complete a spinoff is to solve a strategic or regulatory issue. This typically comes about as a way to adhere to antitrust regulations.
What Happens After A Spinoff?
Every spinoff is different, and it is essential you research the mechanics and reasoning for the Spinoff in the first place. Typically following a Spinoff, the new entity will see a short-term decline in price. A decline in price may seem counterintuitive at first, but if you step back and ask yourself why this might occur the reasoning is simple. Remember, the stock of a spinoff is awarded to current shareholders of the parent company. These holders often are portfolio managers, pension funds, insurance companies, and index funds.
For a portfolio manager, the spinoff might not meet the portfolio’s investment criteria and thus must be sold off. A similar situation happens for an index. The index may have held the parent company based on certain criteria that the spinoff just does not meet, thus creating a need to exit.
Institutions face similar conundrums. As detailed in his book “Margin of Safety, Risk Averse Value Investing Strategies for the Thoughtful Investor,” Seth Klarman describes perfectly as to the dilemma an institutional investor faces;
“An institutional investor managing $1 billion might hold twenty-five security positions worth approximately $40 million each. Such an investor might have owned one million Tandy shares trading at $40. He or she would have received a spinoff of 200,000 InterTAN shares having a market value of $2.2 million. A $2.2 million position is insignificant to this investor; either the stake in InterTAN will be increased to the average position size of $40 million, or it will be sold. Selling the shares is the path of least resistance since the typical institutional investor probably knows little and cares even less about InterTAN. Even if that investor wanted to, though, it is unlikely that he or she could accumulate $40 million worth of InterTAN stock, since that would amount to 45 percent of the company at prevailing market prices (and that almost certainly would violate a different constraint about ownership and control).”
Overall the forced selling that occurs right out of the gate creates an excellent opportunity for smaller investors and value investors alike.
Evaluating A Spinoff
It should come as no surprise that analyzing a spinoff is very similar to evaluating any other investment opportunity. In addition to your usual analysis, you might consider paying particular attention to the following three areas.
First, look at the capital structure of the deal as it pertains to both the parent and the spinoff. It is common for the Spinoff to be loaded up with debt or cash. Loading up the Spinoff is a way for the parent company to transfer these assets and liabilities in a tax-free manner. Understanding what the balance sheet looks like will put you in a better position to analyze the potential performance. Greenblatt was a fan of taking positions when leverage would pay asymmetrical risk rewards. As stated by Greenblatt;
“Believe it or not, far from being a one-time insight, tremendous leverage is an attribute found in many spinoff situations. Remember, one of the primary reasons a corporation may choose to spin off a particular business is its desire to receive value for a business it deems undesirable and troublesome to sell. What better way to extract value from a spinoff than to palm off some of the parent company’s debt onto the spinoff’s balance sheet? Every dollar of debt transferred to the new spinoff company adds a dollar of value to the parent. The result of this process is the creation of a large number of inordinately leveraged spinoffs. Though the market may value the equity in one of these spinoffs at $1 per every $5, $6, or even $10 of corporate debt in the newly created spinoff, $1 is also the amount of your maximum loss. Individual investors are not responsible for the debts of a corporation. Say what you will about the risks of investing in such companies, the rewards of sound reasoning and good research are vastly multiplied when applied in these leveraged circumstances.”
Next, get an in-depth understanding of the incentives management has for performance within the spinoff. Joel Greenblatt used management incentives as his top metric when evaluating a spinoff. Another wisdom snippet of Greenblatt;
“Insider participation is one of the key areas to look for when picking and choosing between spinoffs— for me, the most important area. Are the managers of the new spinoff incentivized along the same lines as shareholders? Will they receive a large part of their potential compensation in stock, restricted stock, or options? Is there a plan for them to acquire more? When all the required public documents about the spinoff have been filed, I usually look at this area first.”
Parent or Spinoff
Finally, be sure to evaluate how both the parent and the spinoff will look post deal. Remember, advantageous opportunities post-spinoff do not reside exclusively in the spinoff. As an individual investor, you have the opportunity to take a position in the parent, the spinoff, or both.
Overall, Spinoffs offer an attractive hunting ground for undervalued opportunities. Most analysts agree as activist funds increase in popularity, more demand will be placed on utilizing spinoffs to further realize shareholder value. Keeping these special situations on your radar will give you that much more opportunity to find a sound investment.