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Beat the Market with Spin-Offs


INTROWhat’s A Spin-off?Should I Buy Into Spin-offs?Conclusion
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Be different, both in life and investing.

Why? Differentiation breeds success. Apple succeeded because Steve Jobs could conceive of revolutionary products far different from those already brought to market. The iPod could store huge amounts of music, and iPhones included a variety of features that were so different from conventional phones.

And you think chasing popular stocks will make you rich? Think again.

Popular stocks tend to be overvalued from excess attention. True value can be better found by focusing on different companies, perhaps in different industries, that provide differentiated products. As an investor, it also pays to think outside-the-box with different investment strategies from the majority of other investors.

That being said, I know a strategy that is so different the average investor hasn't even heard of it. And those who have, simply keep it to themselves.

In this article, you’ll learn all about spin-off investing. Let’s start with the basics.

What’s A Spin-off?

Spin-offs can take many forms but the end result is typically the same. A spin-off happens when a company decides to “let go” of one of its divisions or subsidiaries into a separate, independent company.

It's like a company saying, "This part of our business is doing so well on its own, let's set it free!" Let's say a big company that sells coffee and cookies decides that its cookie division is doing really great.

They might decide to spin off that division into its own company. This new company would then have its own shares that people can buy and trade on the stock market, separate from the original parent company. In most cases, shares of the new spin-off company are distributed or sold to the parent company's existing shareholders.

A great example exists with McDonalds, which acquired Chipotle back in 1998. At the time, Chipotle only had 16 locations within its chain, but it soon expanded quite well under its new fast-casual dining concept. It became lucrative as a stand-alone company. In 2006, McDonald's decided to spin-off Chipotle, and shares of the new spin-off were distributed to existing shareholders.

On the first day of trading as a standalone company, Chipotle shares doubled from $22 to $44! And they have since boomed to a per share price of $2,970 presently (any stock splits not taken into account here). Clearly, releasing good-quality businesses as their own standalone entities can involve huge value creation for the company and ultimately the investor.

You might be asking yourself: “Why would any company do that?” There are a large number of reasons.

For example, perhaps they want to streamline their operations, make things clearer for investors, and maybe even unlock some hidden value along the way.

But that’s not really your question, is it? If you’re anything like me, you’re thinking something else.

Should I Buy Into Spin-offs?

Not every spin-off will outperform. But on average, they do quite well. According to legendary investor Joel Greenblatt, stocks of spin-off companies, and even parent companies that do the spinning off, significantly and consistently outperform the market averages. In a study by Deloitte, spin-offs outperformed the MSCI world index by 22% in the first 12 months of trading. Why?

When a company does a spin-off, they're basically giving out shares to their existing investors instead of selling them like in an IPO. This means there's usually not a lot of hype around the new company. Plus, since it's often smaller and not covered by analysts, institutional investors might not be allowed to buy in.

So, even if the spin-off is valuable, some investors end up selling their shares anyway. Which is an absolute win for bargain hunters.

In case you need more proof, J.P. Morgan studied U.S. spin-offs from 2009 to 2015 and found something cool. The average valuation for these spin-offs went up from 6.9x earnings to 8.6x earnings. Other studies have reached similarly promising conclusions about the prospects of spin-offs for both companies and investors.

But, the big question remains: what can these results mean for you?

Conclusion - Are Spin-offs For Me?

Since spin-offs often fly under the radar of big institutional investors, there's a chance to grab some undervalued gems before they get noticed. Plus, with the potential for increased focus and growth in the spun-off company, it could lead to nice returns.

If the Market tends to generate average annual returns of around +10%, and if spin-off opportunities have typically outperformed the Market by 22% on average, that means there's a potential for investors attentive to spin-off deals have the opportunity to reap returns of 20%-30% simply by targeting a portfolio of recently spun-off companies. The largest stock gains for spin-off companies historically took place not in the first year after the spin-off but in the second, so keep that in mind.

And by evaluating such opportunities even more closely with your due diligence and analysis (without blindly investing in any and all spin-off opportunities that transpire) suggests opportunity for even greater returns than that. In other words, hone in and pick your favorite spin-off situations.

That being said, we know that past results don't always translate to the same results going forward. And these companies can be riskier because they're smaller and less established than their parent companies. Plus, with limited analyst coverage and institutional interest, it could be harder to estimate how they'll perform in the long run. So, as with anything, due diligence and careful analysis is a must.

Read a bit more about spin-offs in this insightful article by FasterCapital. Always follow your inner investor voice. And if you ever want more…

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.

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