How to Invest Wisely in the Stock Market

What are stock spinoffs? Are spinoffs wise investments?

Stock spinoffs are shares resulting from a parent company creating a second, independent company from one of their divisions or subsidiaries. Because shareholders of a new spinoff are typically quick to sell, they often sell below market rate.

Learn how to make a profit from stock spinoffs with these tips from hedge fund manager Joel Greenblatt.

Investing in “New” Companies: Spinoffs, Partial Spinoffs, and Orphan Equities

Greenblatt has many strategies for special-situation investing, including opportunities that arise when established companies beget new companies and stocks. In this section, we’ll focus on three such situations: spinoffs, partial spinoffs, and orphan equities.

How to Profit From Stock Spinoffs

Stock spinoffs occur whenever a parent company decides to jettison one of its subsidiaries or divisions and create a fully independent company. According to Greenblatt, investing in spinoffs can yield above-market returns because shareholders of the new spinoff often seek to hastily sell their shares

Greenblatt clarifies that when a spinoff occurs, the parent company typically distributes shares of the spinoff to existing shareholders. For example, if Warren Buffett’s company—Berkshire Hathaway—decided to spin off Dairy Queen, one of its subsidiaries, then Berkshire Hathaway might distribute shares of Dairy Queen to its current shareholders to compensate them for the value lost when it jettisoned Dairy Queen.

(Shortform note: Spinoffs are similar to Initial Public Offerings (IPOs), as both result in the creation of a new publicly traded company. However, there’s a key difference between the two: IPOs make a formerly private company publicly traded, while a spinoff creates a new publicly traded company from a pre-existing public company.)

In practice, this means that shareholders receive shares that they didn’t ask for—in the previous example, shareholders originally wanted to invest in Berkshire Hathaway, not Dairy Queen. Further, Greenblatt points out that these stock spinoffs are often too small for institutional investors, who only invest in large companies. The upshot is that investors sell the spinoff’s newly created shares in droves, often making the spinoff’s stock available at bargain prices. Greenblatt notes that, for this reason, stock spinoffs have historically outperformed the S&P 500 by 10% annually in their first three years, according to a 1988 study.

(Shortform note: According to a study by Purdue University researchers, this trend was even stronger among stock spinoffs from 2000 to 2013. In this window, spinoffs outperformed market indices by over 17% in their first 22 months on the market. Parent companies likewise beat the market by about 4% in their first 15 months. However, these researchers caution that increasing market efficiency in the future might erase the superior performance of spinoffs going forward.)

Finding the Best Spinoff Opportunities

Although investing indiscriminately in spinoffs could yield above-market returns, Greenblatt writes that one key sign indicates exceptional spinoff investment opportunities. He writes that you should seek spinoffs whose managers receive large stock incentives, because these stock incentives are a proxy for management’s confidence in the new company.

Stock incentives, Greenblatt clarifies, refer to the portion of managers’ salaries that is paid as shares of the company’s stock. Because managers have a say in spinoff structures, it shows they believe in the spinoff’s long-term prospects when spinoffs offer large stock incentives; otherwise, they would choose to be compensated in cash. And because these managers have the best understanding of the spinoff’s business potential, their belief is strong evidence of a good investment. Moreover, Greenblatt notes that large stock incentives demonstrate that managers’ interests are aligned with shareholders’ interests, which is another telltale sign of a promising investment.

(Shortform note: In addition to outright receiving equity in the company, other stock incentives instead grant employees the right to purchase equity at a discounted price. These incentive stock options (ISOs) allow employees to either retain their shares of the company’s stock or to purchase them at a discount and sell them at the market rate, earning a small profit known as the “bargain element.”)

How to Profit From Partial Spinoffs

In a similar vein, Greenblatt discusses partial spinoffs, which occur when a parent company only spins off a portion of a division or subsidiary and keeps the rest. He argues that partial spinoffs can present promising investment opportunities—both in the partial spinoff and in the parent company.

Investing in partial spinoffs, Greenblatt points out, can be lucrative for the same reason it can be lucrative to invest in spinoffs: Shareholders receive unsolicited shares of stock in the partial spinoff and thus have an incentive to sell these shares at a low price. However, Greenblatt contends that the best investment opportunities from partial spinoffs often involve investing in the parent company. He reasons that when a partial spinoff occurs, the market not only prices the spun-off division, but also allows us to calculate the value of the parent company minus the entire spinoff.

(Shortform note: According to experts, different types of investors are attracted to the parent of a spinoff versus the spun-off subsidiary. They point out that, because spinoffs are smaller companies with more potential for growth, they attract more aggressive investors who aren’t afraid of the greater volatility of a small company. By contrast, because parent companies who spin off subsidiaries are larger and more stable, they tend to attract more conservative investors.)

The information we gain from partial spinoffs is valuable, Greenblatt explains, because we normally can’t tell whether the isolated parent company is mispriced since its share price normally includes the value of all the parent company’s subsidiaries. Thus, partial spinoffs allow us to identify underpriced parent companies. 

To illustrate, Greenblatt discusses his decision to invest in Sears after its 1993 full spinoff of Dean Witter and its 20% spinoff of Allstate—its two main subsidiaries. At the time, Sears stock cost $54 per share. The Dean Witter spinoff gave Sears shareholders $15 per share in Dean Witter stock, while the Allstate spinoff gave Sears shareholders $29 per share in Allstate stock. Thus, by purchasing Sears stock, you were effectively purchasing Sears’s department-store business at $10 per share ($54 minus $15 minus $29).

Greenblatt points out that this price constituted a massive bargain—Sears’s department-store business was trading at a large discount to its sales, especially compared to other similar businesses. He writes that, after he purchased Sears stock, it jumped about 50% in the next few months, generating a massive profit.

(Shortform note: Sears’s spinoff of Dean Witter and partial spinoff of Allstate weren’t its only significant changes in 1993—Sears also underwent substantial restructuring, closing 100 department stores and cutting 50,000 jobs. Consequently, the stock might not have risen 50% because its spinoffs shed light on an underpriced parent company, as Greenblatt suggests, but rather because these restructurings created a leaner company.)

Stock Spinoffs: How to Make a Profit From “New” Companies

Becca King

Becca’s love for reading began with mysteries and historical fiction, and it grew into a love for nonfiction history and more. Becca studied journalism as a graduate student at Ohio University while getting their feet wet writing at local newspapers, and now enjoys blogging about all things nonfiction, from science to history to practical advice for daily living.

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