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June 11, 2015

Profiting from Spinoffs

Call it the year of the spinoff.According to research firm Spin-Off Advisors, 60 US companies set up part of their operations as a separate firm last year. To find another year that tops 2014, you have to go all the way back to 1999 and 2000, which tied at 66 apiece.

It remains to be seen whether 2015 will hit last year’s lofty heights, but it’s safe to say it will be close: Spin-Off Advisors expects 50 to 55 splits to be wrapped up by year-end, for the second-highest total since 2000.

Why does this matter to investors? The answer is that spinoffs and their parent companies generally deliver market-beating returns. One way to gauge their performance—and invest in them—is through the Guggenheim Spin-Off ETF (NYSE: CSD).

The fund aims to track the performance of the Beacon Spin-Off Index, which includes mainly small- and mid-cap stocks that have been spun off within the past 30 months but not more recently than six months prior to the fund’s latest rebalancing, which takes place twice a year.

Over the last five years, the ETF has gained 142%, compared to a 96% rise for the S&P 500. It had an off year in 2014, finishing more or less flat, compared to the benchmark’s 12% gain, but it has returned to form in 2015, rising 4.5% versus 1.0% for the S&P 500.

Below, we’ll delve into a few factors driving spinoff performance and some other things to keep in mind when investing in both the parents and newly spun off companies.

First, here’s a quick look at how spinoffs work and why, for some companies, breaking up is the right thing to do.

Spinoffs 101There are a few different ways to execute a spinoff.

The most common is for the parent to hand out 100% of its interest in the subsidiary to its own investors as a stock dividend. Typically, shareholders don’t have to pay taxes on the shares they receive until they sell them.

A good example is Agilent Technologies’ (NYSE: A) spinoff of Keysight Technologies Inc. (NYSE: KEYS). When the spinoff was completed on November 1, 2014, Agilent investors received one Keysight share for every two Agilent shares held. (Agilent makes lab equipment for the food, environmental and pharmaceutical markets, while Keysight includes the former company’s electronics-measuring business.)

Another way a company can carry out a spinoff is by letting its investors exchange their existing shares for stock in the new company, often at a discount.

A third option is what’s called an equity carve-out, or partial spinoff, where a company sells a minority interest in a subsidiary (usually less than 20%) in an initial public offering. In these cases, the spun off firm enjoys greater autonomy but still benefits from the parent’s expertise and resources. Carve-outs usually result in full spinoffs later on.

Pfizer Inc. (NYSE: PFE) went this route when it divested its Zoetis Inc. (NYSE: ZTS) animal-health subsidiary. In February 2013, the drug giant sold 17% of Zoetis in an IPO. Then a few months later, it spun off the rest by letting its shareholders swap their Pfizer shares for Zoetis stock at a 7% discount.

How Two Can Be Better Than OneCompanies often say that a split-up will help the management of the new firms better focus on their core businesses, or that it will let the new company go after opportunities that were previously off-limits.

The trend has been fueled by investor demand for “pure plays”—or companies that focus on only one industry or product—over conglomerates. That’s a big shift from the ’60s, when conglomerates were all the rage because, as the thinking went, their more diversified operations provided steadier earnings and “synergies” that would fetch a higher market valuation.

However, as Investing Daily strategist Jim Fink wrote in a November 2011 article, that line of thinking shifted over time, as many conglomerates morphed into unfocused giants whose strongest profit generators were often buried under a pile of so-so businesses.

“If one of the businesses was a high-growth star, its higher-deserved valuation often went unrealized because investors became distracted by the conglomerate’s other slow-growth businesses,” he wrote.

“Ever since the ’60s, investment bankers have convinced corporations to break up into specialized and focused companies so the most profitable business units’ higher valuations would be recognized by the marketplace.”

Numerous studies have since shown that spinoffs can pay off for investors.

A relatively recent one, released by Credit Suisse in 2012, looked at companies involved in spinoffs over the previous 17 years. It found that, on average, spun off firms outperformed the S&P 500 by 13.4% in the first 12 months, while parents beat the index by 9.6%.

But according to hedge fund manager Joel Greenblatt’s 1997 book, You Can Be a Stock Market Genius,there’s no need to rush in right after a company concludes a split. He cites a 1993 Penn State study showing spinoffs topped the S&P 500 by about 10% a year through their first three years, but their biggest gains came in the second year, not the first.

That may be because investors receive shares in the new company, instead of choosing them on their own, and may feel the stock is inappropriate for them, prompting them to sell. As well, there’s usually scant analyst coverage of the newly spun off firm, prompting outside investors to hold off until the stock establishes more of a history.

“More likely, though, it’s not until the year after the spinoff that many of the entrepreneurial changes and initiatives can kick in and be recognized by the marketplace,” wrote Greenblatt.

Either way, he concludes, the research appears to show that with spinoffs, investors have “more than enough time to do research and make profitable investments.”

Mind the “Stub”One thing Fink and Greenblatt advise is paying attention to the “stub” stock in a corporate reorganization, or what Fink calls the “ugly duckling.”

Take the former ITT Corp., which split into three companies on November 1, 2011: water infrastructure firmXylem (NYSE: XYL); defense and aerospace company Exelis (NYSE: XLS), which generated more than half of ITT’s revenue and operating income; and the “new” ITT Corp. (NYSE: ITT), a maker of engineered industrial products.

At the time, the market placed a higher value on water companies than defense firms; worries about the US defense budget had caused investors to sour on the latter. Exelis had also inherited a significant amount of the old ITT’s debt and pension obligations.

Nevertheless, in his November 2011 article, Fink singled out the slow-growing defense supplier as likely to post the strongest gain of the trio, citing its bargain valuation.

“Everyone is talking about Xylem and the new ITT because of their high projected growth rates, but don’t fall into the ‘growth trap’ and overpay for growth,” he wrote. “Often the best investments are the slow growers that have been excessively dumped at any price by impatient investors.”

Exelis soared 125% between then and May 29, 2015, when it was acquired by Harris Corp. (NYSE: HRS). ITT and Xylem gained 23% and 40%, respectively, in the same period.


Courtesy Ian Fraser for Investing Daily (Archive Here)   

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