“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.
It’s important to follow our investing guidelines when you look at new issues—and spinoffs
Investing guidelines and rules of thumb can help you make better investment decisions. But to profit most from any one guideline, you need to understand why it works. That way, you can determine if the rule makes sense in a particular situation.
Our rule on new stock issues or IPOs (Initial Public Offerings) is simple. We generally stay out of them.
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.
Investing guidelines for 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.
Spinoffs—true undervalued stocks
In one sense, a spinoff is the antithesis of a new issue. Companies sell new issues to the public when they feel it’s a good time to sell. They do spinoffs when they feel it isn’t a good time to sell, often resulting in undervalued stocks. That probably means it’s a good time to buy.
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. Initially there is little, if any, brokerage research available on the 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. You should have the patience to hang on through months of sluggish trading, while reluctant spinoff holders exercise their urge to sell.
More investing guidelines for new stock issues and IPOs
As we mentioned above, new stock issues come to market when it’s a good time for the company or its insiders to sell. That may not be a good time for you to buy. In fact, it’s often a bad time for you to buy, judging by academic studies of new-issue performance.
In addition, brokers reserve their best new issues for their biggest and most co-operative clients—those who do a lot of trading, or who buy every new issue the broker offers them. If you rarely buy new issues, you will rarely if ever be able to buy a significant portion of the best new issues.
Even with attractive new issues, it’s best to stay out. If a new issue has genuine long-term investment appeal, it will be an attractive buy for months or years after it reaches the market.
In the past, however, we have made money by making an exception to the new issue rule. New issues are more attractive and often easier to obtain when they are part of a privatization effort—when a government sells a government-owned enterprise to investors.
In privatizations, governments often price the new issue at an attractive level that almost ensures that buyers will make money. That’s because governments are less concerned than a private seller would be about getting a good price in a privatization. Instead, they are more concerned about maintaining the goodwill of buyers, for political reasons. Rather than try to get the best price, they may sell a privatization at a good price to a wide range of individual buyers, to win goodwill and votes in the next election.
We generally avoid new issues, but new issues of companies being privatized can be a good deal.
Investing guidelines for new issues: Underperforming stocks, not undervalued stocks
We hardly ever recommend buying new issues when they are first sold to the public. For that matter, we generally stay away from new issues for months, if not years, after they first come to market. As a group, new issues underperform the market over long periods. In addition, their results are far more variable than those of well-established stocks, and they expose you to greater risk of major loss.
Of course, many new issues do look like undervalued stocks and go up when they first hit the market. These are the “hot new issues” that everybody wants to buy. Unfortunately, hot new issues are always in short supply. Individual brokers get only a limited allotment, so they usually reserve them for their biggest and most profitable clients.
What other investing guidelines for new issues do you recommend for investors? Share your thoughts with us in the comments.
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