Less Is More When Buying Stock Spinoffs

Physician's Money Digest, May 15 2003, Volume 10, Issue 9

Oppressed by a down market for 3years and running, struggling companieshave discovered that bigger isn't necessarilybetter. Enter stock spinoffs—asmart solution for companies that weremerger-happy in the 1990s. The goodnews for physician-investors: You canprofit by buying shares of the newly spunoffcompanies.

PROFIT FROM SPINOFFS

Wall Street Journal

A steady stream of companies is beingcut loose by their parents, according to arecent report. Therewere 41 spinoffs representing nearly $104billion last year, and several deals havealready been announced this year.

For example, US Bancorp plans to spinoff its Piper Jaffray unit. TMP Worldwideis spinning off its eResourcing unit. Andthe UK's Six Continents wants to breakapart into a restaurant and pubs chainand a hotel company that owns theInterContinental, Holiday Inn, andCrowne Plaza brands.

The flurry of stock spinoffs can betraced to the excesses of the 1990s, whencompanies were determined to furtherincrease their revenues. As a result, therewere a lot of precarious acquisitions.Today, companies are refocusing theirbusiness on core operations. They are castingoff previous acquisitions and distributingto their shareholders the stock in thebusinesses they no longer want.

The investing strategy for spinoffs is incontrast to the investing strategy foracquisitions. In the 1990s, Wall Streetinsiders often made large profits by bettingon companies likely to be takeovertargets. However, the best way to takeadvantage of spinoffs is to wait until afterthey actually occur.

Journal

It may be more tempting to buy sharesin an initial public offering (IPO), whichcan double or triple in value in a singleday. For individual investors, however,investing in stock spinoffs is a safer choice.Also, shares of spinoff companies aremuch easier to buy than are IPO shares.Because the strategy relies on buyingcompanies after they are actually spunoff, the article notes, you canmerely read the newspaper for news ofcompanies announcing spinoffs. Somedeals are not technically spinoffs, merelydistributions to existing shareholders. Yetinvestors tend to treat such carveouts,including IPOs of subsidiaries, as theywould a true spinoff.

Several academic studies have foundthat spinoffs significantly outperform themarket for several years. Experts believeone reason that spinoff companies performwell is because many of them weresmall parts of bigger firms where theywere starved for management attentionand cash to grow. On their own, they havea chance to shine. Another reason: Spinoffcompanies tend to be takeover bait.According to Randall Woolridge—afinance professor at Pennsylvania StateUniversity—these companies are 3 timesas likely as their peers to be snapped up ata premium within the first 3 years.

In 1999, a landmark study revealedthat stocks of spinoff companies outperformedthe market by 22% in the firstyear; over 3 years, they did around 54%better. The study, conducted by anaccounting and finance professor atGeorgetown University, examined 155spinoffs from 1975 to 1991. By contrast,other studies show that IPOs usually performpoorly in the first several years.

A WORD OF CAUTION

Keep in mind, however, that not allspinoffs do so well. Generally, the bestspinoffs are companies that have little incommon with a parent. The bad ones areoften those where a company is simplygetting rid of an under-performing assetthat's closely related to its core business.

Remember that it's best to invest inspinoffs after new shares have been distributedto shareholders. Individual andinstitutional shareholders in the parentcompany frequently don't know what todo with the stock they're given and endup dumping it. Additionally, if the parentis in a stock index, index funds usuallymust sell the shares received in the spinoffcompany since that company typically isn'tin the same index as the parent company.Consequently, the stock price falls temporarily,allowing you to buy it evencheaper.