Why Spinoffs Outperform (Why A Spinoff Is Good)

Do Spinoffs outperform the market? Is a spinoff a good or bad investment?

Evidence points out that spinoffs have historically been good investments, for both the company being spun off and the parent company.

This article explains what a spinoff is, why a spinoff outperforms, why a spinoff is good, and why a company would spinoff part(s) of its businesses.

There are plenty of reasons why a company might choose to unload or otherwise separate itself from the fortunes of the business to be spun off. There is really one reason to pay attention when they do: you can make a pile of money investing in spinoffs. The facts are overwhelming. Stocks of spinoff companies, and even shares of the parent companies that do the spinning off, significantly and consistently outperform the market averages.

– Joel Greenblatt, You Can Be a Stock Market Genious

Joel Greenblatt points out in You Can Be A Stock Market Genious that spinoffs have historically outperformed the market. He presents several case studies to argue his case, but any investor should know that spinoffs are not a sure thing.

Like the rest of the market, the results are skewed to a few outliers that increase the average performance. The median spinoff performs worse than the market.

First, let’s start by explaining what a spinoff is:

What is a spinoff?

A spinoff is a dissolution of the existing company by separating one or more of the parent company’s subsidiaries. The spinoff is a new entity with its own assets, employees, and resources where the parent company’s shareholders are allotted shares in the new entity.

The spinoff becomes a separate company on the exchange, and the shareholders can dispose of or acquire more shares.

A recent example of a spinoff is the elevator company Otis. From 1976 until March 2020, it was part of the industrial conglomerate United Technologies (now a part of Raytheon). Otis is currently an independent company listed on NYSE.

However, most investors like to know if a spinoff is good or bad. And most of the research, to our knowledge, tend to indicate that spinoffs outperform the markets, at least in the short and intermediate time frames, something we discuss further below.

Why does a company spinoff a business?

There could be many reasons why a company would want to spinoff its businesses. Below we list the most obvious ones:

Conglomerate discount

Why would a company spinoff some of its businesses? One reason might be the conglomerate discount.

Frequently the market value a diversified group less than the sum of its parts. For example, a conglomerate of four specific divisions might have a market cap of 100 billion. However, if the four divisions were four independent companies, the market cap could be 125 billion.

Thus, the shareholders are “rewarded”, at least in the short-term, by breaking up the company (or at least part of the company). This is called “unlocking shareholder value”.

An example of a conglomerate is Berkshire Hathaway. Many have argued it should spinoff some businesses, but this is very short-sighted, in our opinion. Even though the sum of the parts most likely is worth more on its own, Warren Buffett’s magic is his capital allocations derived from the cash flows from the underlying businesses. Shareholders need to think long-term when they vote for spinoffs or not. Buffett can reinvest the retained earnings much better than you can.

There might be no buyers

When a conglomerate wants to get rid of a division but can’t find sellers at an acceptable price, a spinoff is the easiest course of action. In most cases, it’s easier to sell a division than it’s to list it as a separate entity.

A smaller unit is easier to manage

The parent company’s management might not have the knowledge or the expertise to manage the relevant division. Thus it might be better to list it as a separate entity. Alternatively, management has less to focus on in a streamlined entity.

Lack of synergies

Some parts of the conglomerate might grow fast, while other parts grow slowly. Moreover, it might be little synergies between some parts of the business segments.

When management has to deal with different businesses, one of them might prove to be a drag on the other. When there is no overlap, the companies are better managed separately than under one umbrella.

In Berkshire, various businesses can thrive because of the hands-off approach by Buffett. Buffett focuses on capital allocations, not managing the businesses which are better left to the local managers.

Antitrust rules

Many companies are forced to split up their businesses: antitrust laws make spinoffs prevalent in industries with very monopolistic tendencies or are highly regulated.

Is a stock spinoff good or bad?

There is no exact answer to this question. Sometimes it makes sense; other times, it might be the result of short-term activists with no interest in the company’s long-term prospects. The four reasons explained above indicate that management needs to evaluate its pros and cons in each case.

One of the benefits is that a spinoff company might be easier to understand and analyze. A company that’s easier to analyze is, in most cases, valued at higher multiples. The sum of the parts, when they are separate, thus make them more valuable.

At the end of the day, most of the evidence suggests that spinoffs perform better than the market:

Do spinoffs outperform the market?

Spinoffs outperform the market, at least in the short-term. The Edge Group and Deloitte published a research paper in December 2014 called Global Spinoffs & The Hidden Value of Corporate Change.

Their survey looked at all spinoffs listed on an exchange on all exchanges in the Western world from 2000. The return one year after the spinoff is summarized in this table:

	Parent company	Spinoff	Reference index
Global/all countries	14%	22%	1%
USA	21%	27%	3%
EU	10%	20%	1%
Rest of the world	3%	18%	-1%

The reference index is MSCI World for “Rest of the world”, the S&P 500 for the USA, and STOXX 600 for the EU. Both the parent company and the new entity outperform the market.

However, 40% of the spinoffs don’t show a positive return. Thus, the result is skewed to a relatively few listings that perform very well.

In a more recent study from 2017, done by S&P Global, the positive returns for the spinoffs are confirmed:

 

The returns are not immediate as the first month shows weak performance, but the result improves the longer the time horizon (up to three years). The parent companies, however, show mixed results.

In a recent article in Forbes, Jonathan Boyar argues spinoffs have underperformed over the last decade. He explains why:

1. The growth in passive investing: Active investors have less capital available to buy shares of spinoffs causing shares to languish.
2. Increased shareholder activism: Activists have been active, but the unintended consequence is that we have seen more low-quality businesses being spun-off, resulting in weak returns.
3. Pruning corporate deadwood: More companies are spinning off dressed-up units. This is good for the parent company, but not so much for the new entity.

As you can see, as is always the case with the stocks market, nothing is written in stone.

To do well, you need to pick stocks – something which is very challenging no matter the strategy you chose, as the famous study by Hendrik Bessembinder from 2017 reveals (Do Stocks Outperform Treasury Bills?).

Why do spinoffs tend to perform well?

The most likely reason is “unlocking” shareholder value. This is in most cases a short-term effect and might explain the low correlation with the overall market during the first year of listing. The new entity might increase its earnings multiple from, say, 15 to 18, thus increasing value.

Likewise, the parent company might be valued more because it got rid of a business that was not desired by the market. In the short term, the most likely reason is valuation.

In the long term, a business’ valuation is linked to its performance. We have not seen any studies that measure the performance after three years, which would be very interesting.

Conclusion

Spinoffs outperform seem to be a good investment and tend to outperform, but markets go in cycles. No strategy performs well all the time, something that applies to spinoffs as well. However, the evidence suggests outperformance over time.