The Spin on Spinoffs
Andrew He, Victor Yan
In investing or trading, there are various strategies investors use to make profit, such as value investing or momentum trading. However, as the saying goes, it is the areas that are least focused upon that yield the greatest opportunities. With that in mind, this article will focus upon the niche area of investing known as spinoffs investing.
To give context on the returns of spinoffs, the 30 day return of spinoffs on average registers a -2.28% return. However, after 3 years it yields 22.00%. Deloitte and The Edge found that since January of 2000, the worldwide asset class of spinoffs has generated over 10 times the average gains of the MSCI World Index during their first 12 months independent of the parent. Hence, it is clear, with a longer investing time horizon, spinoffs overall do have a positive return.
What is a Spinoff?
A spinoff is when a parent company separates one of their divisions/businesses and lists that entity on the market. This spinoff creates an independent company and the shareholders of the original parent company are usually distributed shares for the newly listed company on a pro-rata basis.
For example, if I bought into a parent company with a stake of 100 shares and it spun off a subsidiary as a separate entity, as an original shareholder of the parent, I will be allocated shares in the new spinoff. This is on a “pro-rata” basis – meaning proportional. For instance, a 5:1 split will see me receive 1 share in the spinoff entity for every 5 shares I hold in the parent company. Thus, I am to maintain my 100 shares in the parent, while receiving 100/5 = 20 shares in the new spinoff. Simply put, the value of the parent company is split between itself after the spinoff and the spinoff itself.
|Before Spinoff||After Spinoff (5:1 Split)|
|Shareholding in Parent||100 shares @ original parent value||100 shares @ parent ex-spinoff entity value|
|Shareholding in Spinoff Entity||0 shares||20 shares @ spinoff entity value|
Technicalities aside, the best way to think about a spinoff are parents (the parent company) that send their kids (the spinoffs) off to college. In their youth, children are born and raised with their parents under the same roof, operating as a family. However, as college students, they are “released” off to the real world (ie. spinoffs established as their own separate company), however still with a loose connection to their parents (ie. parent shareholders are distributed spinoff shares).
Why do they occur?
The real question is why do spin offs occur? There are three core reasons: valuation, managerial efficiency, and strategy:
From a valuation perspective, a company with many different subsidiaries is difficult to value the entire company, even under a “sum of the parts” approach. Smaller subsidiaries may not be well described in annual reports and financial statements which form the basis for analysts’ reports. Hence it is easy for the market to undervalue the subsidiary. Spinning off a division enables greater clarity as there is more public information regarding that particular division which will lead to more accurate valuations.
From a managerial perspective, spinoffs subscribe to the notion that it’s better to be a shark in a small pond than a fish in the vast ocean. Having their own entity to operate reduces pre-existing departmental conflicts and ensures that the original management can better focus on the divisions they understand rather than wasting time on a division they are less knowledgeable about.
For strategic reasons, a division which is performing exceptionally well can perform even better if it is a standalone company with its own resources and capital. Within a conglomerate a number of divisions may compete for capital thereby resulting in the well-performing division receiving less of a share than it merits. Management might then realise that it would be a good opportunity for that division to operate on its own as it requires its own capital and management. An example of this would be the Dulux (DLX) demerger of Orica (ORI) in 2010.
Why are Spinoffs Attractive?: Market Price Perspective
Now that we understand what a spinoff is, why focus on this type of special situation as a promising investment? In fact, spinoffs shares are by and large, negatively biased and underappreciated by the market when they are first distributed to shareholders.
In most cases, the original shareholders invested in the idea of the broader parent company, not the spun-off portion. Consequently, upon being allocated a stake in the spinoff entity, a great deal of shareholders participate in indiscriminate selling of these shares and choose to take profits.This tendency to sell leads to a strong selling pressure on the share price of the newly minted spin off.
This selling does not only occur on the retail side, but also from institutions subject to an investment mandate. For instance, superannuation funds may only be able to invest in large-cap companies in the ASX200. In most cases, spinoffs are much smaller than their parental counterparts, perhaps only 10% of the size. Institutions and funds must adhere to their investment mandates and are thus effectively forced to sell their spinoff shares.
These institutional mandates not only place restrictions on investment only by size, but often also the type of business and perceived risk level. Generally, it’s rare for an institution invested in the parent company to find that its spinoff satisfies all their criteria, hence resulting in indiscriminate institutional share dumping.
What’s important to point out is that the fundamentals of the business being spun offhave not changed due to this demerger – they are still in the same business with the same clientele and the same capital and resources, but trading at a lower price due to being systematically neglected. Of course, with prices trading low at roughly undisrupted value, a higher deviation between price and value in this sense would imply higher attainable profit.
Why are Spinoffs Attractive?: An Intrinsic Value Perspective
The value proposition only improves from here. Not only does price plummet from value due to the excessive dumping of spinoff shares mentioned before, but spinoffs themselves often see the value of the business rise above their previous levels. In this sense, you can effectively “kill two birds with one stone”.
Why is this? Well this boils down to 2 main reasons: (1) Focus from management, and (2) focus from the market.
Thinking about managerial focus, imagine being in charge of a mass conglomerate with many subsidiaries in different industries. This makes it hard for management to maintain a clear focus across various industries and make optimal capital allocation decisions among the businesses they control. Similar to overloading in university, it makes it more difficult to learn each topic properly. You only have so much time and so much concentration. Management teams overwatching multiple businesses often end up spreading themselves too thin, taking on too much responsibility but achieving little to nothing in the end.
Additionally, management compensation schemes can be better aligned to performance. For example, under a parenthood structure, as long as subsidiary management can be confident that the broader company performs well, there is little incentive for them to pull their weight since at the end of the day, management is compensated with stock options that are pinned to the performance of the parent company. Hence, they are essentially awarded for the subsidiary’s inertia.
However, being “exposed” as a separate entity with its own shares, all noise is removed as spinoff management have to prove their worth. Their stock based compensation is now determined purely by their own success, without the possibility of hiding behind their siblings or parents. This transparency helps derisk the investment in spinoff shares as management aligned to put their best foot forward, likely leading to better business performance.
The other catalyst comes in better market attention towards the spinoff. After all, if parent management finds it hard to oversee all its subsidiaries, what hope is there for the shareholder receiving the overcrowded annual report on all these businesses?
Realistically, most investors don’t have the time nor care to review this information, and will focus on the parent company’s main businesses – these neglected subsidiaries merely being a footnote in their minds. However, under a spinoff, these companies are allowed exposure in the market as “themselves”, without being overshadowed by their “siblings” under the parenthood structure.
Thus, revising our price/value chart, we see that spinoffs can potentially create not only an investment opportunity from a price drop, but also a higher value in the business as a result of this type of demerger. According to a Penn State study, the largest stock gains for spinoffs took place on average in the second year, where the first year involved a lot of indiscriminate selling pressure, but the ball gets rolling in the second year where better management and market attention causes a firming in the spinoff’s stock. Overall, this only results in a larger price to value crater that makes this special opportunity all the more attractive.
In the world of investing where so much attention is dedicated towards your news grabbing blue chips, unicorn growth companies and sexy M&A deals, spinoffs are often left hiding deep within the dark shadows. Yet, for those willing to shine their torch into the territory of these special situations, they are often left realizing a company that is one person’s trash, but this person’s treasure.
With a fresh canvas and ideas spurred on by focused management, the act of spinning off essentially gives the company a “new face” for investors to look at – the perception being that this is an up and coming company that has a lot of growth potential. What may have once been neglected as a minor dump-off from retail and institutional portfolios all alike may storm back under a new reinvention as a young, dynamic company under a new stock ticker.
In this piece, we have introduced the concept of a spinoff, why they occur, and why these neglected instruments can potentially yield promising returns. In the following sequel to this multi-part series, we will look into the signals behind identifying what makes a good spinoff.
Joel Greenblatt: You Can Be a Stock Market Genius
Edited by Dominic Holden, Gary Palar and Charlie McMillan Summons
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.