Profit From Special Situations – Spinoffs

In part three of the series on special situations, where the little guys have the advantage over the big guys, we’ll be taking a look at spinoffs. This series is based on the book You can be a stock market genius! so for additional information, be sure to read it yourself.

New here? Catch up on the series.

Part 1: Odd Lot Tenders

Part 2: Book review on You can be a stock market genius!

What is a Spinoff?

Spinoffs can take many forms but a simple definition can be defined as a corporation taking one of its subsidiary or business division and then separating it to create a new company. A spinoff usually occurs because the company wants the public to fully recognize the underlying assets of the division and to get a better valuation of the whole company. The newly created company is then valued by the market independently.

Why Spinoffs?

The first good sign is that spinoffs in general beat the market. There is a chance that a spinoff index “could” serve better than an index fund. But why? The short answer is the people that receive the shares, usually don’t want it. If the spinoff is performed via an IPO, that would be a different story as people interested in the spinoff are the buyers.

Now if a spinoff occurs so that a previously hidden asset is desired to be recognised, you would think that people would hold onto the shares for dear life. Not the case. E.g. If company ABC is a car manufacturing company with a tiny car alarm division, it is safe to assume the shareholders may not want to hold a car alarm company. Their original intention was to own ABC as a car manufacturer. Thus, there is a strong selling pressure following the spinoff. Other selling factors include:

1. people bought a car manufacturer, not a car alarm company
2. they don’t understand the business of the spinoff
3. it may not fit with their investing allocation or strategy
4. the spinoff size may be a small or micro cap, preventing safety seekers or institutions to hold onto the shares
5. debt from the parent could be loaded off to the spin off

All of the above reasons cause short term selling pressures which usually result in sharp price drops within the first few weeks.

Spinoff Characteristics

Here are some characteristics that can point to an exceptional spinoff opportunity.

1. Institutions don’t want it. As mentioned above, institutions have a to abide to rules such as not owning more than a certain percentage. They end up selling without even looking at the business and investment merits.
2. Insiders are incentivised and want the spinoff to succeed. Will they be receiving stock, options or preferred stock as compensation? Analyze management compensation plans, actions and motives. Insiders should have a vested and active interest in the new company with a large incentive.
3. Previous hidden investment opportunity is uncovered.
4. Keeping an eye on the parent company can also pay off.

Some Remarks

Partial spinoffs and rights offering are also just as profitable as spinoffs but due to my lack of experience in this area, I’ll be skipping this additional section. As I find examples of past partial spinoffs and rights offerings, I’ll provide an update post when I grasp the whole picture.

In the meantime, for commentary on upcoming or recent spinoffs, Stocks Spin Off blog provides useful information.

Lastly, as I don’t want reader attention to wane, I’ll leave spinoff examples for the next post.

[tags]special situation, spin off [/tags]