If you own a portfolio of large-cap stocks, it’s not a matter of if but when you will receive shares of a stock spin-off.
Just take United Technologies, which recently spun off two separate companies, Otis Worldwide (OTIS) and Carrier Global Corporation (CARR).
Further, the remaining aerospace company was merged with Raytheon to create an aerospace and defense juggernaut. To further confuse the issue, it kept the Raytheon (RTN) name.
When you receive shares in a spin-off, it’s difficult to find information related to the new company or companies that you now own.
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But before we cover what to do when you receive a spin-off, let’s take a step back.
What is a Stock Spin-off?
A stock spin-off occurs when a publicly traded company separates part of its business into a second public company and distributes its shares in the new business on a pro-rata basis to existing investors.
Spin-offs occur because management thinks their business is undervalued by the market, and believes (with good reason) splitting the business up into a simpler structure will force investors to re-value the spin-off and parent more in line with comparable companies.
How Do Spin-offs Perform?
In short, they perform well and many famous investors advocate for investing in spin-offs.
Peter Lynch, who famously generated 29.2% annual returns while managing Fidelity’s Magellan Fund, wrote in One Up on Wall Street, “Spin-offs often result in astoundingly lucrative investments.”
Joel Greenblatt, a lesser-known but equally impressive investor who generated 50% annual returns while managing Gotham Capital, was also a proponent of spin-off investing. He wrote in You Can Be a Stock Market Genius, “You can make a pile of money investing in spin-offs. The facts are overwhelming. Stocks of spin-off companies significantly and consistently outperform the market averages.”
While spin-offs won’t outperform every year, numerous studies show that over the long term, stock spin-offs do quite well.
For example, Credit Suisse found that U.S. stock spin-offs outperformed the market by 13.4% in the first 12 months of trading.
What To Do When You Receive a Spin-off
Given the long-term performance of spin-offs, it’s usually a prudent decision to hang on to the shares of any spin-off that you receive.
Take Otis Corporation and Carrier Global Worldwide, the two spin-offs that we discussed above. Both of these companies have sold businesses, will continue to grow with the global economy and trade at reasonable valuations. They have cyclical exposure (especially Carrier), but over time, they should both perform well.
Nonetheless, there are two questions to consider when deciding whether to sell a spin-off.
- Is the spin-off paying exorbitant high interest on its debt?
- Is the spin-off’s business in secular decline?
If the new spin-off has debt and its cost of interest is at 10% or higher, bond holders have expressed serious concerns about the staying power of the business. This is a serious red flag.
Take Quorum Health (QHCCQ), a 2016 spin-off from Community Health Systems (CYH). Bond holders priced Quorum’s debt at 11.6%, an incredibly high interest rate especially considering how low rates were (and continue to be) around the world. Investors would have been smart to sell their spin-off shares of Quorum Health as the company performed poorly and recently declared bankruptcy.
The second question relates the outlook for the business.
If the spin-off’s business is in secular decline, it’s usually a good decision to sell the stock, even at a cheap valuation.
Take CBS Radio, which was spun off and merged with Entercom Communications (ETM) in November 2017.
The radio business generates good cash flow but is in secular decline. Again, investors would have been wise to sell ETM after the CBS Radio spin-off as shares are down 83% since the transaction.
Of course, usually it pays to hold onto your spin-offs or buy more.
Consider PayPal (PYPL), a 2015 spin-off from eBay (EBAY). PayPal is up 318% since its first day of trading!
Or Zoetis (ZTS), a 2013 spin-off from Pfizer (PFE), up 344% since.
Or Bioverativ, a 2017 spin-off from Biogen (BIIB), which was acquired by Sanofi (SNY) a year after its spin-off for 138% higher than its spin-off price
Those are the kinds of returns that make investing in stock spin-offs worth the risk.
Timothy Lutts heads one of America’s most respected independent investment advisory services. Each week, Tim personally picks the single best stock in his exclusive Cabot Stock of the Week advisory. Build your wealth and reduce your risk with the top stock each week for current market conditionsLearn More