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The following is an excerpt from, “Spin-Offs—Finding Buried Treasure in Corporate Discards,” which can be found at www.kirrmar.com.
As “value” investors, we look for stocks with limited Wall Street recognition or that are otherwise out of favor.
Our experience has been that corporate restructuring often creates market inefficiencies, allowing us to buy at a significant discount.
Many investors look at spin-offs as corporate waste, orphans pushed to the side to let parent companies shine. We disagree.
A spin-off can come in many shapes and sizes, but the result is the same: A parent company distributes all or most of its ownership of a subsidiary to shareholders, and a new company emerges.
If the parent’s and subsidiary’s businesses are unrelated, separating them can enable investors to better understand and value each firm. In other words, a spin-off can create parts worth more than the present whole.
A spin-off also can separate a “bad” business from a “good” business. That frees the management of the good business from worrying about the bad business. Concurrently, the bad business’s management team can focus solely on improving its operation, unshackled from the constraints of the combined entity.
Once a subsidiary’s shares are distributed to the parent company’s shareholders, they are typically sold immediately, with little regard to price or intrinsic value. All in all, the spin-off process is a fundamentally inefficient method of distributing stock to the wrong shareholders.
This is a market inefficiency that can be exploited. If you are willing to invest the time and effort, the potential is great.
A spin-off can unleash entrepreneurial forces in the newly formed company. Incentives tied to the parent firm and/or its stock might not mean much, but with independent financial results and a separate stock price, the concept of accountability takes on a new meaning.
A body of academic study and Wall Street analysis of spin-offs occurring as far back as 1965 shows stocks of spin-off companies significantly and consistently outperform the market averages.
This research also indicates spin-off stocks outperform versus similar market-value stocks in the same industries. One potential explanation, according to a 1994 study in the Journal of Applied Corporate Finance: evidence “strongly suggests that spin-offs are accompanied by substantial improvements in operating performance and profitability.” Data also shows parent firms and spin-offs were five times more likely to be taken over than other firms.
The anomaly persists. From its inception on Dec. 31, 2002, through June 29, 2012, the Bloomberg U.S. Spin-Off Index had a total return of 243.5 percent versus 87.4 percent for the S&P 500.
How can this anomaly continue if investors know it to be true? For the same reason value investing outperforms growth over a long time. It’s hard work combing through and analyzing a thick SEC filing. And by definition, you’re buying something that has been discarded and is out of favor.
However, if you have the stomach and psyche for investing in spin-offs and are willing to do the work, there can indeed be treasure buried in corporate discards.•
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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.
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