Fall in Love With Spinoffs

It's time. It's time to show some love for one of the most consistently outperforming, yet unappreciated areas of the market. If I told you that you could exceed market returns by 19.4%, 24.4%, and 26.3% over 12, 24, and 36 months by buying one type of investment would you be interested? A study done at Purdue University covering a 36 year period between January 1965 and December 2000 revealed that subsidiaries spun off from the parent company averaged exactly these returns.

You don't need to look far to prove this to yourself, there's an ETF that follows a similar strategy, the Guggenheim Spin-Off ETF . This ETF consists of roughly 24 spinoffs that have been publicly traded between six and 30 months. Since its inception in mid-December 2006, CSD has appreciated 70% compared to only 27% for the S&P 500. This ETF captures much of the outperformance one can expect by investing in spinoffs, and provides a relatively diversified way of doing so. For those who believe in love at first sight, this might be all you need.

For those who want an even more fruitful relationship with their investments, I'm going to show you how to meet or even exceed the alluring returns listed at the beginning of this article. The astute reader will realize that much of the excess return actually occurs in the first year after a spinoff. This is a contentious point among many spinoff research articles. Prevailing wisdom on Wall Street surmises that the best time to purchase a spinoff is after the first six months. The McConnell and Ovtchinnikov research from Purdue indicates that excess returns can be found in the very first month a spinoff is public. Investing in CSD might handsomely beat the market, but you're missing out on the first six months of excess returns.

In his classic book You Can Be A Stock Market Genius, Joel Greenblatt provides some additional advice for the spinoff investor. Joel advocates looking for these two characteristics:

1) Institutions don't want the spinoff, and not because of the company's investment merits

2) Insiders want the spinoff

One person's trash is another's treasure
Companies spin off a division for a multitude of reasons. Unrelated divisions can be separated so they are better appreciated by the market. Sometimes a "bad business" is spun off so the untarnished good business has a chance to shine. In other cases, a business is spun off in order for the parent to solve a strategic or regulatory issue, thus paving the way for further transactions. No matter the case, companies often choose to spin off segments of the business that are much smaller than the core. When a spinoff occurs, the owner of the parent will typically be given X number of shares for every Y number of shares owned of the parent.

For example, when Oneok spun off One Gas last month, shareholders received one share of One Gas for every four shares owned of Oneok. An interesting thing happens when investors receive stock in a company they neither specifically purchased nor sought out: They often sell it without regard to price or value. An individual investor who invests in Oneok for its exposure to extracting and processing natural gas may not want to hold on to shares of One Gas, which is now a pure-play natural gas utility.

Similarly, a mutual fund with holdings in Oneok, which maintains a portfolio of large-cap stocks found in the S&P 500, may have no choice but to sell OGS, a mid-cap stock. Other reasons may include a lack of available information, no track record as a public company, or unproven management. Any information for would-be investors would likely need to be extracted out of arduous SEC filings. All of these characteristics can add up to an artificially depressed stock price and one heck of an opportunity.

Follow the insiders
Another characteristic to look for are the actions of insiders, which can tell you a lot about the prospects of the spinoff. Are high-level executives from the parent jumping ship to run the subsidiary? How are the new executives being compensated? What stock options are being offered to management? This leads to another hidden advantage to the spinoff investor: There isn't a lot of hoopla made before the first trading day on spinoffs. Unlike IPO's, there isn't a horde of investment bankers drumming up support at their institutional clients, and there isn't the allure of massive first day gains. Instead, spinoffs often appear quietly, almost sneaking into the market, showing up in the accounts of individual and institutional investors who aren't even sure if they want them.

Believe it or not, this actually benefits insiders. Insider compensation packages are often based on the initial trading prices. A low initial stock price can make for an easy hurdle for stock options. Also note, these are stock options in a company where the new management now has 100% control. No longer will insiders need to compete with other subsidiaries for capital or have bonuses held back by the performance of the overall business. The cure for the "Conglomerate Discount" is to be set free, to unleash the pent up entrepreneurial spirit that drives all companies in control of their own destiny.

Another thing to keep in mind is the continued relationship between the parent and subsidiary. Will the parent retain a percentage of ownership in the spinoff? Does it have a stake in the success or failure of this newly created entity? A parent will typically load a spinoff with a fair amount of debt. At the early stages it may be unclear of the subsidiary's ability to pay down this debt. If the parent still has skin in the game, it is less likely it'll burden the spinoff with more debt than it can handle.

Bottom line
In summary, spinoffs as a whole can provide captivating returns. Take advantage of early indiscriminate selling from institutions and individuals, but don't wait too long to establish your position; excess returns can happen as early as the first month. Pay attention to insiders, especially any high level executives of the parent choosing to run the subsidiary, and the incentives offered to them. Finally, take note of the parent-subsidiary relationship post-separation. Following these guidelines will have you falling in love with spinoffs.

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The article Fall in Love With Spinoffs originally appeared on Fool.com.

Adam Macko has no position in any stocks mentioned. The Motley Fool recommends ONEOK. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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