Spinoff Value Investing: The Ugly Duckling Of Investing

This article on Spinoff Value Investing was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by Simon Cunningham, edited by Broken Leg Investing.

Today, it's popular to think that an investor is acting like a smart value practitioner by buying companies with a strong moat and a promise of long term growth.

While Buffett popularized these investments, value investing goes a lot deeper than simply buying "good firms." In fact, such ideas can easily be abused by anybody who buys stocks for the long run.

In reality, true value investors engage in certain behaviors that separate them from all others. Searching for dirt cheap stocks using unpopular or off-the-beaten-track strategies is one of these behaviors.

One such strategy is the search for profitable corporate events, and one such event is known as a “spinoff.”

What Is A Spinoff?

In his book Margin of Safety, Seth Klarman explains what a spinoff is, providing us with our first taste of spinoff value investing:

“Spinoffs often present attractive opportunities for value investors. A spinoff is a distribution of the shares of a subsidiary company to the shareholders of the parent company. A partial spinoff involves the distribution (or, according to the definition of some analysts, the initial public offering) of less than 100 percent of the subsidiary's stock.”

As Klarman says, a corporate spinoff is an event whereby a parent company creates and sells tradable shares of a subsidiary to owners of shares in that parent company. The parent company may retain partial ownership of the subsidiary but crucially removes its assets from the balance sheet — while making cash in the meantime.

Why Do Spinoffs Exist?

But why would a company wish to sell off all or part of the subsidiary? Klarman is again on hand to explain:

“Spinoffs permit parent companies to divest themselves of businesses that no longer fit their strategic plans, are faring poorly, or adversely influence investor perceptions of the parent, thereby depressing share prices. When a company owns one or more businesses involved in costly litigation, having a poor reputation, experiencing volatile results, or requiring an extremely complex financial structure, its share price may also become depressed. The goal in spinning off such businesses is to create parts with a combined market value greater than the present whole.”

The potential benefit of a corporate spinoff to a parent company is twofold. First, a company can rid itself of subsidiaries that are underperforming, not strategically viable, or represent a legal liability to the parent company. Second, by selling off the subsidiary, the parent company can realize the fair/intrinsic value of a subsidiary, while converting illiquid, non-current assets to liquid cash. This is particularly attractive if the parent company is looking to invest in new projects or expand its operations through acquisitions.

Why A Spinoff Matters To You

Now that we understand the meaning of, and reasoning behind, a corporate spinoff, we can begin to understand the reason why such an event creates an investment opportunity in the form of spinoff value investing. Unsurprisingly, and as is often the case when it comes to value investing, the irrational behavior of the market plays a major role, asKlarman explains:

“Many parent-company shareholders receiving shares in a spinoff choose to sell quickly, often for the same reasons that the parent company divested itself of the subsidiary in the first place. Shareholders receiving the spinoff shares will find still other reasons to sell: they may know little or nothing about the business that was spun off and find it easier to sell than to learn; large institutional investors may deem the newly created entity too small to bother with; and index funds will sell regardless of price if the spinoff is not a member of their assigned index. For reasons such as these, not to mention the fact that spinoffs frequently go unnoticed by most investors, spinoff shares are likely to initially trade at depressed prices, making them of special interest to value investors. Moreover, unlike most other securities, when shares of a spinoff are being dumped on the market, it is not because the sellers know more than the buyers. In fact, it is fairly clear that they know a lot less.”

As we see, there are numerous behavioral reasons why spinoffs often represent valuable investment opportunities. Regardless of their motivation, the blind and ignorant selling by individuals, institutions, and index funds (ETF’s) of spinoff shares creates an immediate — and probably unfair —oversupply of their shares. Therefore, in Klarman terms, spinoff shares, by their very nature, incorporate a discount — and, therefore, a margin of safety — in their market price, compared to all other shares, on average. This fact alone should make spinoff value investing an attractive prospect for any value investor.

Value Investing And Spinoffs

One of the reasons that spinoff value investing makes for excellent hunting grounds is that blind selling is not the only reason for the existence of the opportunity. As Klarman explains:

“Wall Street analysts do not usually follow spinoffs, many of which are small capitalization companies with low trading volumes that cannot generate sufficient commissions to justify analysts' involvement. Furthermore, since a spinoff is likely to be in a different line of business from its corporate parent, analysts who follow the parent will not necessarily follow the spinoff. Finally, most analysts usually have more work than they can handle and are not eager to take on additional analytical responsibilities.”

So, due to their relative unimportance in the grand scheme of things, even those people whose job it is to analyze companies do a poor job of tracking spinoffs. This makes perfect sense. Why would an analyst bother to track the “new,” relatively small player, when they still have the industry giants to contend with? The answer to this question appears to be that they probably wouldn’t.

Fortunately for us, the reasons that spinoff value investing represents an opportunity don’t stop here! Klarman fills us in further:

“Some spinoff companies may choose not to publicize the attractiveness of their own stocks because they prefer a temporarily undervalued market price. This is because management often receives stock options based on initial trading prices; until these options are, in fact, granted, there is an incentive to hold the share price down. Consequently, a number of spinoff companies make little or no effort to have the share price reflect underlying value. The management of companies with depressed share prices would usually fear a hostile takeover at a low price, however ‘shark-repellent,’ anti-takeover provisions inserted into the corporate bylaws of many spinoffs, serve to protect management from corporate predators.”

“Another reason that spinoffs may be bargain priced is that there is typically a two- or three-month lag before information on them reaches computer databases. A spinoff could represent the best bargain in the world during its first days of trading, but no computer-dependent investors would know about it.”

So, in addition to ignorance and lack of interest, it is possible — if not probable — that managers of the subsidiary will do their best to keep the company under the radar. It is also the case that until the company’s financials become available to investors, those companies won’t appear on stock screeners.

Spinoffs: A Practical Example

Reader: So, Jack, let me get this straight — you’re telling me that not only are most investors almost completely ignorant of the advantages of spinoff value investing, but even the guys who understand it don’t have any interest in these companies? Furthermores, management are incentivized to keep the stock price down? And, to put the cherry on top, even if investors do become aware of a spinoff, do understand how they work, do care, and are interested in investing in this space, they are unlikely to do so due to the difficulty in sourcing financials for the company? Does this not make spinoff value investing literally the picture-perfect value investment? Why is everyone not doing this?!?

Me: Yes, reader, yes, you are correct.

Of course, everyone likes a good theory, but we like it even better when there is physical proof that the theory works. Fortunately, Klarman even provides an example for us:

“Consider, for example, the spinoff of InterTAN, Inc., by Tandy Corporation in late 1986. InterTAN had a book value of about $15 per share, net-net working capital after all debt of roughly $11 per share, and highly profitable Canadian and Australian retailing operations. Large operating losses in Europe camouflaged this profitability and caused a small overall loss. It was clear to anyone who looked behind the aggregate losses to the separate geographic divisions that the Canadian and Australian operations alone were worth considerably more than the price of $11 per share at which InterTAN stock was trading.”

“An institutional investor managing $1 billion might hold twenty-five security positions worth approximately $40 million each. Such an investor might have owned one million Tandy shares trading at $40. He or she would have received a spinoff of 200,000 InterTAN shares having a market value of $2.2 million. A $2.2 million position is insignificant to this investor; either the stake in InterTAN will be increased to the average position size of $40 million, or it will be sold. Selling the shares is the path of least resistance, since the typical institutional investor probably knows little and cares even less about InterTAN. Even if that investor wanted to, though, it is unlikely that he or she could accumulate $40 million worth of InterTAN stock, since that would amount to 45 percent of the company at prevailing market prices (and that almost certainly would violate a different constraint about ownership and control). Needless to say, the great majority of Tandy's institutional shareholders simply dumped their InterTAN shares. InterTAN received no Wall Street publicity, and brokers had no particular incentive to drum up interest in the stock. As a result, waves of institutional selling created a temporary supply-and-demand imbalance, and numerous value investors were able to accumulate large InterTAN positions at attractive prices. By 1989 the company had turned its money-losing operations around, Wall Street analysts who had once ignored the stock had suddenly fallen in love with it, and investors no longer worried about what could go wrong, focusing instead on what might go right. The shares peaked that year at 62.”

The example that Klarman provides is an excellent depiction of how a spinoff can work out. In the case of InterTAN, many of the factors that lead to undervaluations in spinoffs played out — large-scale selling by institutional investors and a lack of in-the-know retail investors available to pick up the slack led to sharp falls in the share price of InterTAN. In addition, a lack of interest amongst Wall Street analysts meant that very few people even were aware that the spinoff was taking place. Another group of agents — company management — likewise did not raise the public’s attention. Finally, while there was information regarding the subsidiary available in the parent’s financials, it was “hidden” within the notes of the annual report, and so would not have appeared on stock screeners. All of these factors came together to create an excellent value prospect.

Tying It Together

To pull all of this together, essentially what we have when it comes to spinoff value investing is a massive opportunity. Combining all the theoretical reasons why it might work with the observational evidence that it does work in practice, we have very good reason to believe that there is massive opportunity accruing to anyone who takes an interest in spinoff value investing.

About as much of an off-the-beaten-track investing strategy that one could find, spinoff value investing provides a perfect example of the type of strategy that separates long-term “value” investors from true value investors. As value-seekers ourselves, we could do worse than to adopt a spinoff value investing strategy within our portfolios.

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