When stock markets are bullish, that usually means that corporate earnings are also very positive. And when that occurs, companies often consider selling off parts of their organizations, frequently in the form of spin-off stocks. A spin-off is simply when a division or subsidiary is separated from its parent company, and begins its life as an independent, spin-off stock.
Since 1990, corporations have been spinning off subsidiaries at an average rate of about 50 per year. Those statistics included quite a few years of very bullish markets. The sectors for the spin-offs are very broad, with the most reported in the healthcare, automobile/transportation, and entertainment arenas.
And the bottom line of all this spinning off is very good for investors: a plethora of studies have concluded that spin-off stocks average a return that is 10% higher than the broad indices in the first year.
Spin-off stocks are so popular, there’s even an exchange-traded fund, Invesco S&P Spin-Off ETF (CSD), that investors can buy to easily get in on the action.
Not All Spin-Offs Are Created Equal
However, just like with any equity, investors must approach spin-offs with an analytical eye. Many spin-offs are winners, but others aren’t.
First, you need to determine why the spin-off is occurring.
There are a couple of good reasons:
- Activist investors are urging companies to unload non-related business divisions that they believe are holding a company back.
- Spin-offs can unlock value in a company, making the sum of the parts greater than the whole. They often allow management to bring a laser focus on individual units that have gotten lost in the shuffle of the conglomerate, giving them a chance to grow into viable businesses. And that can provide opportunities for investors to buy bargain-priced companies with fabulous potential.
There are several catalysts that boost spin-off prices:
- Management is more incentivized by way of stock options and shares.
- The company’s leaders have more leeway to cost-cut and to begin new enterprises.
- Focus on a pure-play company can uncover significant investment potential, as they are easier for investors to understand.
Spin-off stocks are often undervalued because investors may sell the new company if it doesn’t fit their particular investment strategies or disciplines. And often—due to their mandates for investing in stocks of specific market caps—index funds often retain the parent shares and dump the spin-off, which can undervalue the spun-off stock by as much as 20%.
But investors need to know that there’s no guarantee that the spin-off will blossom. The spin-off companies tend to be higher-beta stocks that underperform in weak markets and outperform in strong markets, making them more volatile, and better in bull markets than in a bear environment.
Also, many spin-off stocks sell off right after the separation. But that discontinuity generally goes away over the longer term.
How to Evaluate Spin-Off Stocks
Now that we know that spin-offs can be profitable, how do you know which ones in which to invest?
Here are a few questions to ask when analyzing a spin-off:
- Are the interests of the managers of the spin-off aligned with yours? Are they incentivized through stock ownership to continue focusing on enhancing shareholder value?
- What’s the reason for the spin-off? Evaluate the company’s debt and assets to make sure the ‘bad stuff’ isn’t being dumped into the new company.
- Look at operating income compared to net working capital, less cash to see if the spin-off has strategic advantages.
- Valuation, valuation, valuation—is the spin-off headed for the starting gate with a reasonable valuation? You may have to do a little digging here, to compare the spin-off’s business with its peers to see if a valuation advantage exists.
Fortunately, the Securities & Exchange Commission requires that companies planning to separate file pro-forma statements so investors can take a look-see at what the spun-off company might look like. Those are called 10-12B forms.
The SEC provides a list of upcoming spin-offs.
So how does one invest in spin-offs? There are two alternatives: invest in a spin-off exchange-traded fund (ETF) or invest in a stock once it announces an upcoming spin-off.
The next question is, how do you find spin-off stocks? Well, you can search through the 10-12B forms on the Securities and Exchange Commission (SEC) site by clicking this link. Given current market conditions, it should come as no surprise that there aren’t a ton of spin-offs on the docket right now, but be on the lookout for future announcements once the markets begin to rebound.
Do you invest in spin-off stocks? Why or why not?
*This post has been updated from a previously published version, published in 2021.