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Why Spin-Off Stocks Usually Out-perform The Rest Of The Stock Market


Spin-off stocks are defined as existing subsidiaries or divisions that are separated from the parent company that then become independent publicly-traded companies. The separation usually occurs as a tax-free distribution to existing shareholders of the parent company or as an initial public offering (IPO) by the parent company.

Joel Greenblatt in You Can Be a Stock Market Genius, Journal of Financial Economics 33, Penn State 25-year study: Stocks of spin-off companies outperformed their industry peers and the Standard & Poor's 500 by about 10 percentage points per year.

We've personally been investing in spin-offs since 1993 and started sharing our recommendations in 1998. The strategy of investing in spin-offs is based on studies which have shown that spin-off stocks tend to significantly out-perform the rest of the stock market, but only during part of their existence. A 25-year Penn State study showed that stocks of spin-off companies out-performed their industry peers and the S&P 500 by about 10 percentage points per year. A study by Lehman Brothers showed that spin-offs returned 18.2% above the S&P 500. And as Joel Greenblatt points out in his questionably-named (but worthwhile) book You Can Be A Stock Market Genius, most institutional investors are unable to invest in spin-offs for various reasons (more on this later). Since the vast majority of trading volume is done by institutional investors, the universe of spin-off stocks is mostly left to the individual investor to exploit.

Our Spin-off Recommendations Versus Other Spin-offs and the S&P 500

On average, stocks return about 9%-10% per year. Spin-off stocks average about 19% per year according to the Journal of Financial Economics. The spin-off stocks we've recommended (see our Primary Stock Portfolio) have provided an average return of 31.9% per year, easily beating the market each year since 1998. Our spin-off purchases and subsequent sales have resulted in an average gain of 73.5%with 70.3%of the trades being profitable. There's even a class of spin-offs that we reject as being too risky that have returned 47.9%per year. We classify these spin-offs as Speculative Spin-offs. But why do spin-offs outperform stocks in general?

Why Spin-Off Stocks Usually Outperform

Most businesses are run better when they are out from under the parent company's control. Often the parent company provides little freedom or capital for the subsidiary to thrive prior to the spin-off. But once the subsidiary has been spun off, it is free to make its own decisions without having to obtain the parent's consent. The independent spin-off often out-performs the parent company, especially if the spin-off company's management has been given an opportunity for a big payday based on the performance of the new company. This is usually accomplished with options, stock appreciation rights, restricted stock, or an ownership stake. This even creates an incentive for the spin-off's management to downplay the company's prospects prior to being separated from the parent company. This would be done to get management's initial options to be priced as low as possible in order to maximize management's monetary reward down the road.

When a company is spun off, there are usually very few Wall Street analysts covering the stock, if any at all. With few people analyzing these stocks, it's easier to find the hidden values. Think of it as looking for bargains at a yard sale. Would you rather arrive at the yard sale at the end of the day when many other people have already searched through the items looking for potential treasures? Or would you rather show up two hours before the yard sale is open, before anyone else has had a chance to look for undervalued goodies? Triad Hospitals Inc. and LifePoint Hospitals were two examples of spin-offs with little analyst coverage. A $2,000 investment in either of these companies grew to over $7,300 in three years.

Since 1990 shares of spin-offs returned 18.2% above the S&P 500 -- Lehman Brothers study

A large part of the market's trading volume is done by investors (both individual and institutional) using screening software to filter out a large percentage of the stock universe to narrow down the number of stocks they will then analyze in a more thorough manner. When a company is first spun off, there is usually insufficient published data for the stock to be included in the screening software, therefore spin-offs don't usually show up on investor's radar until the company has had time to mature.

Many spin-offs are focused "pure play" companies that operate in a niche area. This tends to attract buyout offers. In fact, spin-off stocks are four times more likely to be bought out when compared to a typical S&P 500 company. Chaparral Steel Company is an example of a spin-off stock that was bought out after we recommended buying the company. A $2,000 investment in Chaparral Steel Company grew to $15,305 in less than two years.

Some spin-offs, frankly, look like ugly ducklings. The spin-off's industry may be out of favor, the company might not yet be profitable, or the business idea is just too mundane to generate much interest. It's these unloved spin-offs that often become the most profitable for investors. After the company matures and starts showing up in stock screening software and on Wall Street analyst's radar, the management of the spin-off often has had time to make business decisions that improve the company's bottom line, and then investors start snapping up the stock which can send the company's stock skyward. Marine Products Corp. was an example of an ugly duckling that ended up performing exceptionally well. A $2,000 investment in Marine Products Corp. grew to $12,785 in three years.

Spinoffs historically have generated far better returns than the overall stock market, and they continue to shine. Barron's, March 2006

Why The Superior Performance Of Spin-offs Is Likely To Continue

Institutional investors drive the vast majority of stock trading. Many of these pension funds and mutual funds are unable to purchase spin-off stocks because spin-off stocks are usually too small for an institutional portfolio or fall outside of their area of focus. A mutual fund with a $185 billion portfolio that purchased a $500 million spin-off company wouldn't see its fund performance budge, even if the spin-off doubled in value. And that's assuming a mutual fund could buy 100% of the spin-off's outstanding stock, which isn't the case. Usually mutual funds are limited to purchasing 10% of a company. In our scenario, 10% of the $500 million spin-off means the fund would be limited to purchasing $50 million. This may sound like a lot, but $50 million would be only 0.03% of the mutual fund's portfolio. That makes the spin-off not worth the mutual fund manager's time.

Furthermore, many institutional investors are only allowed to purchase stocks in the S&P 500 index, an index that includes only the largest companies in the country. Most spin-offs don't initially start off in the S&P 500, although many gain admission later after growing in size and prominence.

Since 2000, spin-offs have beaten the S&P 500 by 45% while those done since 1990 have topped the S&P 500 by 18%

To sum up, because the vast majority of trading volume is done by institutional investors, the universe of spin-off stocks is mostly left to the individual investor to exploit. Not only are spin-offs likely to continue to significantly outperform the rest of the stock market, they seem to be performing even better lately, according to Barron's: "Since 2000, spin-offs have beaten the S&P 500 by 45% while those done since 1990 have topped the S&P 500 by 18%."

So while spin-off recommendations may be difficult to obtain (our competitor at www.spinoffadvisors.com/research.htm charges an outrageous $24,000 per year), our price is much more reasonable.

***


 
Related Links:
Spin-Off Calendar
Recommended Spin-Offs
Speculative Spin-Offs


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