There was an interesting coincidence in both our Wall Street Best Investments and Wall Street’s Best Dividend Stocks newsletters last month. Each of our Spotlight Stocks are preparing to spinoff into separate companies. I didn’t go looking for spinoffs in choosing our featured companies, but as often happens when the markets become more bullish, spinoffs just occur more frequently, and several of our contributors picked up on that trend. In fact, there are more than 40 spinoffs pending right now—more than the average 33.5 spun-off annually for the past few decades.
In Wall Street’s Best Dividend Stocks, J. Royden Ward of Cabot Benjamin Graham Value Investor recommended Johnson Controls, Inc. (JCI), noting that JCI will split into two segments: Automotive Experience and Power Solutions. The $1.5 billion sale-off should unlock value for the company, allowing it to expand battery technology research and acquire additional businesses for each company. Roy expects a 45% increase in investor value as a result of the spinoff.
Genia Turanova and Stephen Leeb, PhD of The Complete Investor recommended Danaher Corp. (DHR) in Wall Street’s Best Investments. Danaher will split into one segment with various medical and environmental units and certain parts of its other five segments. The second new business unit will be called Fortive, which will hold the industrial technologies and tests and measurement segment—a fragmented and rapidly-growing market—that holds tremendous growth opportunities.
With all of this spinoff activity, two questions come to mind: 1) Why the need for a spinoff, and 2) Does it make sense to keep (or buy) the spunoff company and/or the existing one?
Let’s tackle the first question.
Why is the Spinoff Occurring?
There are a couple of good reasons:
- Activist investors who are urging companies to unload non-related business divisions that they believe are holding a company back.
- Spinoffs can unlock value in a company, making the sum of the parts greater than the whole. They often allow management to bring laser focus on individual units that have gotten lost in the shuffle of the conglomerate, and give them a chance to grow into viable businesses. And that can provide opportunities for investors to buy bargain-priced companies with fabulous potential.
Do Spinoffs Outperform?
The answer—historically—is, yes. according to the Bloomberg U.S. Spinoff Index of companies with a market value of at least $1 billion at inception—for the last decade—average share gains have been 118% in the first three years after the spinoff. That is more than double that of the S&P 500 Index. And for the past five years, the Bloomberg U.S. Spinoff index returned an annualized 25.1%, compared with 16.9% for Standard & Poor’s 500-stock index.
Spinoffs are so popular, there’s even an exchange-traded fund, The Guggenheim Spin-Off ETF (CSD), that investors can buy to easily get in on the action. That ETF has gained 78% in the past five years.
Spinoffs are often undervalued because investors may sell the new company if it doesn’t fit their particular investment strategies or disciplines. And often—due to their mandates for investing in stocks of specific market caps, index funds often retain the parent shares and dump the spinoff, which can undervalue the spunoff stock by as much as 20%.
There are several catalysts that boost spinoff prices:
- Management is more incentivized by way of stock options and shares
- The company’s leaders have more leeway to cost-cut and to begin new enterprises
- Focus on a pure-play company can uncover significant investment potential, as they are easier for investors to understand
Not all is Rosy
But, investors need to know that there’s no guarantee that the spinoff will blossom. The spunoff companies tend to be higher beta stocks that underperform in weak markets and outperform in strong markets, making them more volatile, and better in bull markets than a bear environment.
Too, many spinoff stocks sell off right after the separation. But that discontinuity generally goes away over the longer-term.
How to Evaluate Spinoffs
Now that we know that spinoffs can be profitable, how do you know which ones in which to invest in?
Here are a few questions to ask when analyzing a spinoff:
- Are the interests of the managers of the spinoff aligned with yours? Are they incentivized through stock ownership to continue focusing on enhancing shareholder value?
- What’s the reason for the spinoff? Evaluate the company’s debt and assets to make sure the ‘bad stuff’ isn’t being dumped into the new company.
- Look at operating income compared to net working capital, less cash to see if the spinoff has strategic advantages.
- Valuation, valuation, valuation—is the spinoff headed for the starting gate with a reasonable valuation? You may have to do a little digging here, to compare the spinoffs business with its peers to see if a valuation advantage exists.
Fortunately, the Securities & Exchange Commission requires that companies planning to separate file pro-forma statements so investors can take a look-see at what the spunoff company might look like. Those are called 10-12B forms.
I recently ran a search on upcoming spinoffs to see which companies looked interesting from an investment standpoint. Of the 31 deals I researched (in addition to JCI and DHR discussed above), I found five more that look interesting.
You can see that—for the most part—Wall Street rates most of these parent company stocks as ‘Buys’. I also researched a few technical parameters, and in that arena, each company scored an 80% or better chance of outperformance in the months ahead.
That review, of course, doesn’t tell us anything about the performance of the ensuing spinoff stock. But right now, these five companies are getting a lot of Wall Street attention, as the analysts think there are compelling reasons for the spinoffs. So, roll up your sleeves and see if the spinoff makes sense to you. If so, you might want to dive into a couple—before the new stock is handed out.
Editor, Wall Street’s Best Investments and Wall Street’s Best Dividend Stocks