By Michael Santoli | Thursday, February 7, 2013
Whether the board of Hewlett-Packard Co. (HPQ) is closely studying a plan to break the company apart or not, investors would be wise to focus on the prospects for corporate bust-ups.
Not because they offer compelling drama or represent a rare admission of management failure, but because separating discrete businesses from a parent company is an often logical and profitable move.
Unlike on network TV, where series spinoffs rarely distinguish themselves, on Wall Street the stocks of spun-off companies as a group consistently score hits. The Bloomberg Spin-Off Index, which tracks the stocks of hived-off corporate divisions, is up 41% in the past year, compared with about 12% for the Standard & Poor’s 500 Index.
This ripping gain was particularly pronounced, but the outperformance of spun-out stocks was no fluke. In the 10 years through Dec. 31, an actively managed institutional spinoff strategy of asset manager Horizon Kinetics outpaced the market return by more than seven percentage points annually. A Credit Suisse study last year found that over the prior 17 years, spinoffs beat the S&P 500 by some 13 percentage points in the year following their liberation.
Name-brand spinoffs of the past year or so include time-share business Marriott Vacations Worldwide Corp. (VAC) out of Marriott International Inc. (MAR), up more than 140% since it began trading; online travel portal TripAdvisor Inc. (TRIP) from Expedia Corp. (EXPE), up 66%; energy refiner Phillips 66 (PSX) from ConocoPhillips (COP), up 82%; and cereal maker Post Holdings (POST) from Ralcorp Holdings (RAH).
The 'discovery' of value
The outsized returns from owning spinoffs have been so attractive and consistent over the years that, in theory, they shouldn’t be there. Market anomalies and patterns with a good track record tend not to persist, as opportunity-seeking investors adapt by rushing to bid up stocks with predictable advantages, precluding longer-term outperformance.
Yet for structural and behavioral reasons, the spinoff opportunity abides.
In a typical spinoff, a diverse parent company distributes to its own shareholders new shares in a stand-alone unit. The idea is that the division’s value is not fully reflected in the parent valuation, so separating the businesses allows the market to properly value each one. Additionally, independence motivates management of the subsidiary to run the business more efficiently for long-term growth. Often the new company’s management is served up an easy debut by a parent that lowers expectations and cleans up its books before the handoff.
The mechanics often mean the spun-off company is orphaned at first, its shares lacking analyst coverage, handed to investors who never chose to buy them and often to index funds which must sell them. In the first month or two, therefore, the stocks tend to be pressured by forced selling and investor neglect, before being "discovered," at which point their typical outperformance begins.
Horizon Kinetics, which focused greater attention on the spinoff advantage in a 1996 research paper, calculates that it is not a fleeting trading opportunity, but an attribute that continues to build value two to three years following a corporate split. The firm's $950 million Kinetics Paradigm mutual fund (WWNPX) is approximately 40% allocated to spinoffs.
The current environment is ripe for a pickup in spinoff activity, alongside a prospective rise in corporate acquisitions. With profit margins already wide, top-line growth scarce and capital markets calm, companies are hunting for ways to unlock obscured value and sharpen corporate strategies.
Academic studies spotlighting the "spinoff effect" usually assume a portfolio that blindly buys all spinoffs as they occur -- feasible, but for most investors impractical. There is an exchange-traded fund plying the space, the Guggenheim Spin-Off fund (CSD). It has done better than the broad market, though not quite as well as the spinoff indexes, likely because the ETF doesn’t buy new spinoffs until they have traded for at least six months, well into their discovery phase.
More to come?
Obviously, spinoffs don’t have a perfect hit rate for investors. Orchard Supply Stores Corp. (OSH), handed off by Sears Holdings (SHLD) a year ago, has sagged badly. The two halves of the old Kraft Foods -- Mondelez International Inc. (MDLZ) and Kraft Foods Group (KRFT) -- have slightly lagged the market since their October split, which leaves both potentially attractive for long-term investors now.
Among recent spins, Abbott Laboratories Inc. (ABT) hived off its pharmaceuticals business as AbbVie Inc. (ABBV), which first traded Jan. 2 around $35, and has since edged above $37. Reliant on mature drugs such as Humira and Synthroid, the company is reasonably valued based on new profit guidance for this year of just over $3 per share, while its strong cash flow funds a generous 4.3% dividend yield.
Joe Cornell of Spin-Off Advisors, a specialized research firm in this area, sees upside in the planned separation of News Corp. (NWSA) into the Fox Group cable network and entertainment business and a new News Corp., housing the slower-growth publishing assets. He calculates fair value of the combined units at $32.75 per News Corp. share, 18% above the stock’s current price.
While the value of spinoffs is usually available to investors who wait until they are announced and executed, some investors try to anticipate or even lobby for prospective spins as a means to free untapped value within big, diverse companies.
Among the household names invoked in spinoff discussions among investors lately are Procter & Gamble Co. (PG), which could conceivably look to distribute its Iams pet-food unit, Duracell batteries or even parts of the Gillette business. Investors have agitated for PepsiCo (PEP) to cleave its slow-growth beverage operations from its best-in-class snack-food division.
Analysts have also pushed Johnson & Johnson Inc. (JNJ) to consider splintering into three large companies covering medical devices, pharmaceuticals and consumer goods. Management has resisted the idea, though it is looking at separation options for its clinical testing and, reportedly, its feminine-care unit.