A SPINOFF STUDY
A SPINOFF STUDY
by Chris Mayer
You may have heard the old story about a plumber who comes to a man's house to fix a problem with the plumbing. He comes in, bangs on the pipes once and is done.
"That'll be a hundred dollars," the plumber says.
"A hundred dollars!" the man says. "All you did was bang on the pipes once."
"Banging on the pipes is only five dollars," responds the plumber. "Knowing where to bang - that's ninety-five dollars."
Investing is often about knowing where to bang. The money to be made in investing can often come simply from knowing where to look for bargains. Fortune swims not in the busy waterways, but in the quiet shallows, where people are not usually looking for it.
Examples include small-capitalization stocks, obscure or illiquid securities and uniquesituations - such as spinoffs, divestitures, merger securities, rights offerings, restructurings and a host of other lesser known and underfollowed situations. If you don't know what these things are - don't worry. I'm going to explain one of the best places for individual investors to look for bargains.
Though these special situations, as they are often called, are not usually thought of when one thinks of value investing, the fact is that these activities have traditionally been the province of some of the greatest value investors. These were the kind of rich veins that the young Warren Buffett routinely mined. During his time running the Buffett Partnership (1957-69), before Berkshire Hathaway, there were some years in which special situations made up more than half of his profits.
Of course, Buffett was not the only one dining off the tasty menu in the bistro of special situations. Other sharp-eyed value investors saw the same thing and made it a regular part of their investing diets, and they also enjoyed brilliant success.
Here's the story of one of them: In 1985, a man named Joel Greenblatt started the private investment partnership Gotham Capital. Greenblatt made it his bread and butter to work in the special situations arena. He writes about his experiences in his book, You Can Be a Stock Market Genius, which, despite its moronic title, is a serious treatment of investing and contains a lot of good advice.
Much of the book consists of case studies in which Greenblatt shows you how various spinoffs unfolded - Host Marriott from Marriott Intl., STRATTEC SECURITY from Briggs & Stratton, American Express from Lehman Brothers, Liberty Media from Tele-Communications Inc. (this last one netted investors ten times their initial investment in less than two years) and many others. Each of these experiences teaches us something about investing, in particular about the nature of special situations.
Greenblatt enjoyed tremendous success at Gotham Capital.Every dollar invested in the partnership when it was started in 1985 returned $51.97 by the end of 1994, for an annualized return of 50%. Just think, $1,000 invested in Gotham in 1985 returned $51,970 only ten years later. In January 1995, all capital was returned to the outside limited partners.
While Greenblatt invested in a host of special situations, spinoffs were his favorite play. Why were spinoffs so appealing to Greenblatt and his merry band at Gotham? A little research shows that they had found a crack in the sidewalk of Wall Street, which market-beating investments often slipped through. Greenblatt points to a Penn State study published in 1993 that found spinoffs beat their industry peers and outperformed the S&P 500 Index by about 10% per year in their first three years of existence. That is a large margin of outperformance, but is no anomaly. A McKinsey & Company study also found that spinoffs produced returns in the first two years of independence of more than 27% annualized.
Far from being only a U.S. phenomenon, the same outperformance occurs in other markets. A UBS study of European equities found spinoffs substantially outperformed in their first few years of independence. These studies looked at all spinoffs available in the market.
The individual investor has the advantage of selectivity. We don't have to buy every spinoff, nor do we have to pick them randomly. Assuming the investor can cherry-pick the lot and avoid the dogs, there is a good chance to do even better. You would think that the market would adjust and chip away at those outsized returns. They are a well-known phenomenon, documented and studied. Investors should bid up the shares of spinoffs, and the outperformance should disappear over time. But as Greenblatt and others have pointed out, there are good reasons why the well of promising spinoff opportunities will continue to be refreshed on a regular basis.
But before I tackle the reasons why this apparent inefficiency exists, let us consider the various reasons why companies engage in spinoffs at all:
1. To spinoff an unrelated business. Big unwieldy conglomerates that are involved in everything from insurance to restaurants may decide to separate an unrelated business to unlock the value in that business.
2. To separate a "bad business" from a "good business." Sometimes a company with a profitable core of operations will spin off a laggard that is draining resources and management attention from the main group. Once separated, each of the businesses can stand on their own merits, often to the benefit of both.
3. To unload debt and/or other liabilities. Sometimes a spinoff will be loaded up with debt, freeing the parent company but leaving an overleveraged business in its wake. The spinoffs that have failed have often been of this kind. However, this maneuver can be lucrative for the parent company, as you might imagine.
4. To take advantage of tax benefits. A spinoff can qualify as a tax-free event and may be the most efficient way to pass value on to shareholders. If the company were sold outright, for example, the cash distributed to shareholders would be taxable. There are sound economic reasons for spinoffs, and this may explain their initial outperformance.
Think about it: You have a new company with a new, dedicated management team that is likely to be highly motivated. As Greenblatt writes, "Pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course."
Curiously enough, as Greenblatt points out, the biggest gains from spinoffs often came in the second year, not the first. This indicates that perhaps it takes some time for the changes to kick in and deliver tangible results.
Okay, so we've seen some evidence on spinoff outperformance, and we know the motivation behind spinoffs and why they happen. All of this makes good sense. Now why does Wall Street continue to ignore this apparent low-hanging fruit? There are good reasons for that too.
The first reason is simply that Wall Street and the big institutions don't want them. They are often too small to make a difference. If you own shares in a big company and you are getting some small distribution of shares in a spinoff, it's easier for you just to sell the shares rather than dedicate any resources to try to figure it out. Again, it is too small to worry about.
Plus, if you invested in an insurance company, and suddenly, this insurance company is spinning off its smaller credit card operation, do you get excited? You're not interested in credit cards - you're interested in the insurance company. As Greenblatt notes, "Generally, the new spinoff stock isn't sold, it's given to shareholders who, for the most part, were investing in the parent company's business. Therefore, once the spinoff shares are distributed to the parent company's shareholders, they are typically sold immediately without regard to price or fundamental value."
This usually creates selling pressure on new spinoff shares as institutions unload their stock. Since many spinoffs are small, they have little, if any, analyst coverage. And a freshly minted spinoff is not likely to be an immediate user of Wall Street's services. In other words, it doesn't have investment banking needs, so Wall Street is not likely to be interested in promoting the stock. There is little or no hype surrounding their shares. In fact, management may have an incentive to "talk down" the spinoff, since their incentive stock options are priced at the initial market price of the spinoff shares. In this case, it is in their best interest to start at a low price. Then talk it up and promote it later, sometimes months later.
As Greenblatt says, the inefficiencies in the spinoff market are "practically built in the system" and should continue. Knowing this, how can we take advantage of spinoffs? Greenblatt points to three characteristics of a winning spinoff:
1. Institutions don't want it (for reasons such as those discussed above). Sometimes, very large companies spin off companies that are still quite large and attract a lot of attention. Investors are likely to find the buried treasure in smaller companies.
2. Insiders want it.
3. A previously hidden investment opportunity is uncovered by the spinoff transaction. If you can capture a couple of these, or even one of them, you stand a good chance of having found a potential spinoff winner - and outperforming the market by 10% or more.
The investment idea for this month is a classic spinoff situation that holds all the promise of being a great spinoff - it's too small for the institutions to care about, and its independence uncovers an asset that was previously buried in a huge conglomerate.
Regards,
Chris Mayer
for The Daily Reckoning
posted by jagadish @ 9:37 AM
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