Topic: Spinoffs

How do stock spinoffs work?

stock spinoff

Stock spinoffs can become some of the biggest undervalued stocks in the market

We can still say without reservation that, in investing, stock spinoffs are the closest thing you can find to a sure thing.

When a company carries out a spinoff, it sets up one of its subsidiaries or divisions as a separate firm, then hands out shares in the new company to its own shareholders. It may hand out the shares as a special dividend or give its investors an opportunity to swap shares of the parent company for the shares of the newly established spinoff.

How stock spinoffs reward patient investors looking for undervalued stocks

When a spinoff begins trading, it stands to reason that investors will put a low price on it. After all, the spinoff hits the market with a large number of neutral, if not reluctant, stockholders who have limited expectations for it, and who are willing to sell when they get around to it. Moreover, there is often little, if any, brokerage research available on the new company.

The only investors who might be willing to buy a new spinoff are seekers of undervalued stocks who have taken the trouble to read the voluminous material that companies hand out as part of the spinoff process. But on the whole, it pays to follow the lead of these value seekers, and to hang on through months of sluggish trading while reluctant spinoff holders exercise their urge to sell.

4 benefits of stock spinoffs

  • More flexibility. Spinning off unwanted assets lets parent-company managers focus on the part of their business they want to retain. Usually they hold on to the part best suited to their talents.
  • Spinoffs are born with the proverbial “silver spoon.” Parent companies may devote great effort to ensuring they have adequate finances and strong management. They want the spinoff to succeed, for their own prestige, and because they want spun-off bargain stocks to benefit their shareholders.
  • Spun off shares often slump when they begin trading. Many investors routinely dump stock they receive in a spinoff. They may only get a handful of shares — perhaps one for each 10 shares they own. They may have little familiarity with the shares, and coverage by brokerage analysts and the press is often minimal at first. But after this initial slump, these spun off bargain stocks generally go on to outperform the market as a whole.
  • Spinoffs may facilitate takeovers.

Studies have shown the value of stock spinoffs

Study after study has shown that after an initial adjustment period of a few months, spinoffs tend to outperform groups of comparable stocks for several years. (For that matter, the parent companies also tend to outperform comparable firms for several years after a spinoff.) Spinoffs’ above-average performance makes sense for a couple of reasons.

First, company managers naturally prefer to acquire or expand their assets, not get rid of them. Getting rid of assets reduces a company’s total potential profit. This cuts into the funds available to pay managers and reduces their opportunities for career advancement. The management of a parent company will only hand out a subsidiary to its own investors if it’s nearly certain that the subsidiary, and the parent, will be better off after the spinoff than before.

Second, spinoffs involve a lot of work and legal fees. The parent will only spin off the unwanted subsidiary if it can’t sell the stock for what it feels it’s worth. That’s why companies only have an incentive to do spinoffs under two sets of favourable conditions: when they feel it isn’t a good time to sell (which often means it’s a good time to buy) or when they feel the assets they plan to spin off will be worth substantially more in the future, possibly within a few years.

Quite often, a big company will spin off a small subsidiary because it feels the subsidiary is a tiny gem but is too small to make an impact on the parent’s much larger financial statements and market capitalization.

Overall, stock spinoffs often lead to success

We’ve had great success with a number of spun off stocks over the years. That’s especially true of the many spinoffs we have recommended that have gone up after they began trading and have later attracted a takeover bid at a substantial premium over the market price.

Needless to say, things don’t always work out this well. Spinoffs and their parents do sometimes run into unforeseeable woes. But on the whole, in investing, spinoffs are the closest thing you can find to a sure thing.

When you’ve experienced a stock spinoff, did you hold both stock in the parent company and the spinoff, or did you sell one?

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