A corporate spin-off and a new issue or IPO are like two sides of a coin—one favourable to investors, the other unfavourable
From time to time, companies set up one or more of their divisions or subsidiaries as an independent firm, then hand out shares in that company to their own investors as a special dividend, or “corporate spin-off.” Baxter International and eBay are two major companies that have done it with great success.
They outperform comparable stocks for years
“We can say without reservation that, in investing, spinoffs are the closest thing you can find to a sure thing. It all comes down to the incentives when companies spin off a subsidiary or division and hand out shares to their shareholders. 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….” Pat McKeough shows how spinoffs and other “special situations” can create windfalls for informed investors.
In the case of Baxter International (symbol BAX on New York), it spun off Baxalta (symbol BXLT on New York) as a separate division in July 2015. The remaining company, Baxter, is now focused on medical devices, such as intravenous pumps and kidney dialysis equipment. Baxalta makes vaccines and drugs in three main areas: hematology (blood diseases), immunology (immune system) and oncology (cancer). Since the spinoff, Baxalta shares have moved up steadily.
eBay (symbol EBAY on Nasdaq) also spun off its PayPal online-payment division as a separate firm in July 2015. eBay investors received one PayPal share (symbol PYPL on Nasdaq) for each share they held. PayPal processes online transactions, including purchases made through eBay’s auction websites. In the past few years, it has expanded into stores and mobile payments.
As a separate firm, PayPal will be able to pursue alliances with more retailers and cut its reliance on eBay. It recently added new customers, like Macy’s department stores and America Movil, a Mexican wireless provider. PayPal is also moving into new areas, such as loaning funds to small and mid-sized businesses.
A corporate spin-off versus a new stock issue
You can contrast a corporate spin-off with a new stock issue, which is when a company first sells shares to the public.
The two situations are like two sides of a coin—one favourable to investors, the other unfavourable. The motivations of the companies are nearly opposite.
Companies sell new issues to the public when they feel it’s a good time to sell. That may not be, and often isn’t, a good time for you to buy.
In addition, the underwriting brokerage firms try to spark publicity about the new issue, and they pay extra commission (as much as double the regular rates) to spur their salespeople to sell the new issue to their clients. This tends to create a high-water mark in the price of the new issue. Unless the new company can follow up with business success, the price of the new issue may languish for months or years
Some new stock issues—so-called “hot new issues”—depart from this pattern. They begin moving up as soon as they hit the market. Some even “gap upward” on their first day of trading—that is, their first public trading takes place well above the new issue price.
This possibility attracts buyers who fail to appreciate how rare it is. In addition, the underwriting brokers can generally tell when this is going to happen, by judging the reaction of their biggest clients (who of course get first pick on their new issues), and the media. They reserve most of their allotments of hot new issues to their biggest and best clients.
New clients and occasional new issue clients may get to buy only token amounts of a hot new issue, if any.
Speaking very generally, your best course of action as an investor is to stay out of most new issues. You’re better off to wait until they have been trading for a few years and have shown some of the potential that the initial hype promised.
When it comes to a corporate spin-off, the situation—and our advice—is largely the opposite. A number of studies have shown that after an initial adjustment period of a few months, spin-offs 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 spin-off. That 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, which reduces the funds it has available to pay its managers. The management of a parent company will only hand out a subsidiary to its own investors if it’s fairly confident that the subsidiary, and the parent, will be better off after the spin-off than before.
Second, corporate spin-offs 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 spin-offs 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.
Oddly enough, many investors react to spin-offs as a nuisance, because they leave you with a tiny holding in a stock you didn’t choose and know little about. As a result, these investors may dump any spin-offs they receive as soon as they get around to it. They’d be better off to buy more of any spin-off they receive, because spin-offs seem to come with the odds set in the investors favour.
Needless to say, things don’t work out this well every time. Corporate spin-offs and their parents sometimes run into unforeseeable woes. However, human nature makes it a good bet that both the parent and spin-off will prosper.
Has one of your investments been part of a corporate spin-off? How did it go? Did the spin-off company become just as successful as its parent? Share your experience with us in the comments.