Spinoffs: The Special Opportunities to Earn Big Returns

by | Jan 23, 2023

What is a spinoff?

“A spinoff is when a company takes a subsidiary, division or part of its business and separates it from the parent company creating a new, independent, freely standing company.”

Joel Greenblatt, You Can Be A Stock Market Genius

On 24 August 2020 Smith & Wesson Brands, Inc (SWBI) spun off its outdoor products and accessories business American Outdoor Brands, Inc (AOUT). This created two independent publicly traded companies: Smith & Wesson Brands, Inc. (which would encompass the firearm business) and American Outdoor Brands, Inc. (which would encompass the outdoor products and accessories business).

Why would a company do a spinoff?

Companies usually conduct a spinoff for one or more of the following reasons.

  1. By separating an unrelated business from the parent company both businesses can be better assessed by the market.
  2. Desire to separate a ‘bad’ business from a ‘good’ one.
  3. Create value from a business that is difficult to sell
  4. Tax considerations
  5. Antitrust or regulatory issues

In the Smith & Wesson example, the company gave the following reason for the spinoff. 

“The purpose of the spin-off is to enable the management team of each company to focus on its specific strategies, including (1) structuring its business to take advantage of growth opportunities in its specific markets; (2) tailoring its business operation and financial model to its specific long-term strategies; and, (3) aligning its external financial resources, such as stock, access to markets, credit, and insurance factors, with its particular type of business.”

Why you should know about spinoffs?

A study from Penn State found that over a 25-year period ending in 1988 spinoff companies outperformed the S&P 500 by about 10% per year in their first three years. The parent companies outperformed their industry by more than six per cent during the same three-year period. Other studies since then have had similar results.

Why do spinoffs outperform?

Shareholders initially don’t want the spinoff stock. When a spinoff occurs shareholders of the parent company will be given shares in the spinoff company. Shareholders likely bought the stock in the first place because they like the parent companies business and not for the business of the spinoff. When the spinoff occurs the shareholders will typically sell their shares in the spinoff driving down the price. This gives you a good opportunity to buy while the price is low.

Institutions may be forced to sell the spinoff stock. The spinoff company could be much smaller than the parent company. Some institutional investors are limited to buying large companies such as those in the S&P 500. If the spinoff is too small institutions may be forced to sell it. Again this provides an opportunity to buy while the price is low. 

The spinoff creates two management teams who can focus on their own unique businesses. Management will have more accountability, responsibility and incentives to perform well. This should be rewarded with an appreciation of the stock price.

The purpose of a spinoff is to create shareholder value. Managers don’t always have shareholders’ interests in mind. Many are more interested in building their own legacy by growing the company no matter the cost. A spinoff is usually done when shareholders are at the forefront of management’s mind.

They allow pure-play bets. Markets tend to prefer companies with businesses in a single industry over conglomerates. Separating two different businesses can attract new investors.

They allow investors to pigeonhole their investments. Investors like to pigeonhole their investments. That is they may want to buy one company because it pays a predictable dividend and they want to buy another because it has massive growth potential. When a company owns two businesses with different characteristics it is a turn off for investors. By spinning off one of these businesses investors looking for a specific type of investment can be attracted.

Things to look for in a spinoff

Institutions don’t want it. Institutions may be forced to sell the spinoff due to its small size. This will drive down the price initially.

The spinoff has a different business model. Investors of the parent company own the stock because of the parent company’s business model. They may choose to sell the spinoff because they are not interested in it. In the above example, investors may have chosen to invest in Smith & Wesson Brands, Inc for its firearm business. They may choose to sell American Outdoor Brands, Inc. because they aren’t interested in the outdoor products and accessories business. This will drive down the price initially.

Insiders want it. We want insiders to want to own the stock. A sign of this is that insiders will receive compensation in stock or options. This means insiders will have an interest in the stock performing well. 

A hidden investment opportunity is uncovered. Sometimes a spinoff can uncover an investment opportunity that was previously hidden. This could be a business whose earnings, cashflows or assets aren’t being accurately valued by the market. 

The best time to buy a spinoff

When buying spinoffs you want to wait for the initial selling pressure to end. It’s difficult to determine how long this can take. This post from stockspinoffinvesting.com suggests waiting at least 6 trading days before buying. 

According to the Penn State study discussed in You Can Be A Stock Market Genius the largest stock gains took place in the second year of independence. This means you should buy within the first year of the spinoff.

Summary

  • A Spinoff is when a business, division or subsidiary is separated from the parent company creating two independent companies.
  • There are many reasons a company may choose to do a Spinoff such as separating unrelated businesses, separating a bad business from a good one, creating value for shareholders, tax considerations and anti-trust issues.
  • Spinoffs tend to outperform the market in their first three years.
  • Reasons for this outperformance include initial selling pressure from institutions and shareholders driving down the price. Once this selling pressure is released the price often recovers due to better management, and the attraction of new investors. 
  • When investing in spinoffs you should look for the following things: a reason for institutions to sell, such as small size; a reason for shareholders to sell, such as different business models of the parent and spinoff; a reason for insiders to want the stock to perform well, such as stock-based compensation, an opportunity not yet realised by the market, such as unrealised earnings or undervalued assets.
  • The best time to buy a Spinoff is when the initial selling pressure has subsided. Outperformance usually starts in the second year after the spinoff suggesting you should buy within the first year. 

Want to learn more about Spinoffs and other special investing situations? Grab yourself a copy of You Can Be A Stock Market Genius by Joel Greenblatt (affiliate link).

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