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As a value investor, I am constantly looking for new trading strategies in my efforts to significantly outperform the market. I want to find undervalued stocks that have the potential for great breakouts in price so that I can maximize my returns. In today’s article, I’m going to be discussing the hidden value in spinoffs that could make you over 10% return in a matter of weeks.

 

Spinoff Overview

 

A spinoff is simply a parent company selling or distributing shares of a new subsidiary company. When a spinoff occurs, the new subsidiary company is listed on the exchange with its own number of outstanding shares and its own share-price. A company may perform a spinoff for a variety of business reasons but the main 3 reasons are the following:

 

  1. Subsidiary Business is Underperforming-the subsidiary business may be dragging down the parent company’s financials and performance. The parent company sees them as more harm than good for the longevity of their business.
  2. Parent Company Needs to Focus on Core Competencies- sometimes the parent company is struggling to grow and has a part of their business that is not in line with their core competencies. This may be a new and upcoming part of their business but currently it does not align with their goals. In order to improve their company, they decide to spinoff this side business so that they can focus on their main strengths and improve shareholder value.
  3. Unrelated Businesses are Separated to reach their true potential- a business may be comprised of segments that are in completely different industries. For example, a company may be simultaneously in the natural gas and real estate sectors. They work jointly within this particular company but may perform better and be appreciated more by the market if they were on their own.

You can think of a spinoff like an unhealthy relationship. Either your significant other is dragging you down or you are just not right for each other. A breakup should be beneficial to you both!

A great example of this would be Disney spinning off ESPN. Currently, Disney owns ESPN and they have been underperforming lately which has impacted Disney’s share price. If Disney decides they would be better off without ESPN, they could spin off that company and ESPN would list on the exchange by itself.

**Important to Note** When a parent company spins off a side business their share price will be reduced to reflect the corporate action. Remember the side business adds to the value to the parent company’s market capitalization. If we remove that business the parent company’s market cap goes down which in turn will reduce share price.

 

What do shareholders receive?

 

Now that you have a basic understanding of spinoffs, let’s move into some of the more specific details. If you are a current shareholder of the parent company when a spinoff occurs, you will have a variety of options at your disposal. Typically, shareholders receive payment in the form of a stock dividend. For example, let’s say you owned Disney and our ESPN spinoff REALLY happened. Disney shareholders might be entitled to 3 shares of ESPN stock for every 1 share of Disney that they hold. The terms and conditions of each spinoff with differ but generally this is what you will see. Shareholders are often offered the shares of the new subsidiary company at a discount as well. For instance:

  • Disney announces the spinoff of ESPN.
  • Shareholders are entitled to 3 shares of ESPN stock for every 1 share of Disney that they hold.
  • Shareholders will receive their shares at a price of $23.00/per share.
  • ESPN will begin trading 11/30/2017 at a price per share of $23.50

As you can see, you acquire shares of ESPN at $.50 cent premium. After you receive the shares you can choose to hold onto them or sell them immediately at market.

 

Hidden Value

 

Now you may think the hidden value comes from already being a shareholder when this spinoff occurs BUT that is not the case! The hidden value is most often found in the subsidiary company! A study completed at Penn State, covering a 25-year period ending in 1988, found that stocks of spinoff companies significantly outperformed the S&P 500 by about 10% per year in their first 3 years of being listed on the exchange. I believe we can see a similar pattern in today’s markets as well.

In most cases, when a parent company says they are performing a spinoff, they indicate it is because that part of the business is underperforming. Immediately, so many people overlook the new subsidiary stock because of this and don’t take a closer look at its actually value. Here are some keys to finding spinoffs that have a ton of value:

  1. Institutions don’t want it

Most spinoffs only comprise of less than 10-15% of the total market cap of the parent company. Institution investors and mutual fund managers aren’t very interested in something with this small of market cap. Also, shareholders of the parent company see this spinoff company as garbage since they see it as something that is dragging their shareholder value down. They are likely to sell the shares they receive immediately which will temporarily drive the stock price down on the subsidiary company.

 

  1. Insiders Want the Stock

When a company performs a spinoff, you have to pay close attention to insider activity. If you see a major player in the corporation holding on to a big stake in the new company then there could be a ton of value from the spinoff. At the same time, you need to look out for stock options tied to the new company. Are corporate executives going to receive a large compensation package comprised of stock options in the spinoff company? The greater interest in the spinoff company by insiders the greater chance that there is tremendous value to be found.

 

  1. Value in Spinoff Company going Solo

When a spinoff occurs a SEC document, called a Form 10, will be released that details everything about the new company. If you dissect this document, you will get a great understanding about the spinoff company and the industry in which it conducts its primary business. Sometimes companies don’t have any synergy working together but working separately they can dominate in their sector. If a spinoff company is undervalued when they are first listed on the exchange, we can see a huge jump in their share price as we begin to see how much earnings per share they can provide on their own.

 

**Important Note** While I believe that the greatest hidden value is in the spinoff company we can also see tremendous value in the parent company after they shed that part of their business. The parent company’s share price is reduced so you can buy in at a lower price and they should be able to function more efficiently because of this corporate change. If the spinoff company has significantly been weighing them down, we could see a breakout in their earnings as well.

Analysis of Spinoff Performance

 

Below I have created a couple of tables that show the spinoff performance activity. I made two separate table comparing spinoffs in a bull and bear market. The first table shows the most recent spinoffs to date and the second table shows spinoffs from late 2015 into 2016.

 

Table One: Bull Market (11/1/2016-2/16/2017) Dow Jones Average Return: 11.94%

 

Company NameTickerSpinoff CompanyTickerSpinoff DateCurrent Date% Performance of Parent Since Spinoff% Performance of Spinoff Company% Movement of Spinoff in first 3 weeks
BiogenBIIBBioVerativBIVV2/1/20173/25/20174.02%10.95%7.07%
Varian Medical SystemsVARVarex ImagingVREX1/28/20173/25/201714.40%19.48%24.72%
IntrexonXONAquaBounty TechnologiesAQB1/18/20173/25/2017-30.77%-1.89%-1.25%
XeroxXRXConduent IncorporateCNDT1/3/20173/25/201712.10%6.07%12.49%
Hilton WorldwideHGVHilton Grand VacationsHGV1/3/20173/25/20171.73%6.41%5.76%
Hilton WorldwideHGVPark Hotels and ResortsPK1/3/20173/25/20171.73%-18.27%-1.67%
Overseas Shipholding GroupOSGInternational SeawaysINSW11/30/20163/25/201729.78%27.71%-10.31%
ConAgraCAGLamb WestonLW11/9/20163/25/201715.44%24.91%1.45%
ArconicARNCAlcoaAA11/1/20163/25/201729.31%32.13%29.48%

 

Table Two: Bear Market (11/1/2015-02/16/2016) Dow Jones Average Return: -9.11%

 

Company NameTickerSpinoff CompanyTickerSpinoff DateCurrent Date% Performance of Parent Since Spinoff% Performance of Spinoff Company% Movement of Spinoff in first 3 weeks
WR GraceGRAGCP Applied TechnologiesGCP2/4/20163/25/2017-0.93%48.50%4.91%
IAC InteractiveIACMatch GroupMTCH11/19/20153/25/201714.08%14.99%1.68%
GAMCO InvestersGBLAssocaited Capital GroupAC11/30/20153/25/2017-23.77%19.51%5.08%
Computer SciencesCSCCS Government ServicesCSRA11/27/20153/25/201754.50%0.20%-7.42%
DardenDRIFour Corners Property TrustFCPT11/9/20153/25/201728.05%11.74%4.11%
ArchrockAROCExterranEXTN11/3/20153/25/2017-9.26%36.08%-10.29%
Northstar Reality FinanceNRFNorthstar Reality EuropeNRE11/2/20153/25/2017-23.93%-37.46%-56.40%
Hewlett-PackardHPQHewlett-Packard EnterpriseHPE11/2/20153/25/201720.31%18.75%-28.38%

 

As you can see, in the long-term, the spinoff company had a positive return 88% of the time (16/18 results) It is important to keep in mind that the companies that have performed the best have been the ones with the attributes described above:

  • Institutions don’t want it
  • Insiders want it
  • Spinoff Company can outperform on its own

You absolutely HAVE to dissect the form 10 documents that come out on these companies to understand if they would be a good investment opportunity. These forms usually come out MONTHS in advance before the spinoff actually happens so you really have no excuse to be lazy!

 

Homework: Look into a recent spinoff or an upcoming spinoff and find the form 10 detailing the new company to be listed. Find any of the key factors we talked about and see if this would be a good investment opportunity.