I like to call spinoffs the Wild West of Wall Street. This is where companies and investors alike often ‘shoot from the hip’ in terms of taking chances and throwing money around.
Of course, spinoffs are an area of the market where big money is made…but also where big money is lost.
So how can you pick out the diamonds from within the mud? Like this…
Compared to the benchmark S&P 500 index in the past 6 years, the median spinoff has underperformed by 2.6 percentage points.
But why? The logic of spinning off a part of a company for the right reasons is sound…
In theory, a piece of a larger company should be able to grow faster on its own than as a part of the whole. Let’s say Company A is a big technology company. Company A’s biotechnology branch is struggling while everything else is performing well.
So, Company A decides to separate biotechnology into its own operation.
This should do 2 things on paper:
1. Shed the parent company of an underperforming piece, which should allow it to focus on what it does best, much like shedding weight on an aircraft to make it go faster.
2. The underperforming piece should be able to grow faster on its own, and could possibly be revitalized as it’s now no longer just a small section of a larger company.
That, however, is not the reality for many spinoffs.
In fact, a much less positive situation is often the case. Take Rayonier (RYN) for example. RYN split off into a timber real estate investment trust Rayonier Advanced Materials (RYAM), but neither company did well.
Over a period where the S&P 500 gained 9.5%, RYN fell 29% and RYAM fell 67%. Not exactly what they were hoping for with the spinoff, I suspect.
But the opposite does indeed happen, and can be the diamond in the mud for investors who pick it out. And that diamond could translate directly into bundles of cash…
Since Valero Energy (VLO) spun off CST Brands (CST), VLO has gained by 98% and CST has gained by 38% while the S&P 500 climbed by 42%. That’s an success story that made many investors a nice chunk of change.
So how do you pick out the good spinoff situations from the bad ones?
Focus on these aspects of the situation:
- What’s the motive for the spinoff? Does the parent company want to look good at the expense of the spinoff, or is it truly a solid business decision?
- Avoid lots of debt. A spinoff can often be forced as a result of debt issues, and that can easily cause even bigger problems after a spinoff.
- Avoid high market valuations. Those expectations make it more likely for both the parent company and spinoff to miss estimates, which can quickly pull the bottom out from under both stocks.
With that being said, a good spinoff is a good spinoff, and that can be an incredibly profitable opportunity. As long as you do your homework and see sound reasoning for a spinoff, both the parent company and spinoff operation could be worth investing in.
