We are always looking for ways to find value in the stock market trading. Our search includes researching for traditional value stocks and finding ways to identify high probability opportunities in growth stocks. We have researched momentum, size and other factors. Many strategies can be applied profitably. We also apply less well known strategies. These trading strategy often require more work but can offer larger rewards.
Over the years, one of the strategies we have used with success involves spinoffs. A spinoff is a corporate transaction that is intended to unlock shareholder value. Based on experience, we know investing in spinoffs can be profitable. Within the past few weeks, a new research report was published that confirms our experience. This week, we want to share some insights from that research into spinoffs with you because we believe this research can help you benefit from these relatively easy to spot trading opportunities. They are easy to spot because each spinoff is announced with a news release from the company. Before the deal is completed, regulatory filings provide details on the financial aspects of the deal.
To begin with, let’s define exactly what we’re talking about. When a company completes a spinoff, it is creating a new independent company by distributing new shares of an existing business or division of the parent company. Usually shareholders are given shares in the new company based on their ownership of the existing company, After the transaction, they will own shares in two publicly traded companies. Business might complete a spinoff to streamline their operations or more commonly to unlock shareholder value.
When a Board of Directors decides to spinoff a division, they are sending the market a message. They believe the individual parts of the company should be trading at a higher price. But, they recognize investors have concerns about something that is weighing down the stock price. By spinning off a division, they hope to alleviate these concerns. They believe after the transaction is completed, investors will focus on each part as a standalone business. Often, the value of the parts will add up to more than the company’s pre-spinoff market value. That’s the goal, and that is spinoffs unlock shareholder value.
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As an example, a company might separate a mature, slow growing division so management can focus on a division with better growth prospects. The two, separate companies are expected to be worth more as independent entities than as parts of a larger business.
Spinoffs are fairly common, with a few dozen transactions occurring in a typical year according to analyst estimates. Data provided by FactSet includes information about more than 300 separate transactions completed over the past ten years.
It takes time to complete a spinoff. The process usually begins with a Board of Director’s decision to sell part of the business. When they can’t find a buyer, they can be forced to give the business away and let shareholders decide where they want to invest. From this perspective, these transactions can be thought as failed transactions since it wasn’t possible to find a buyer.
Market performance shows a few interesting trends related to spinoffs.
In the months before the deal is announced, the stock tends to deliver better than average performance. FactSet’s data showed that in the six months before the announcement, stocks gain an average of 13%. This could show news of the deals leaks out but more likely means that management is focusing on making the financials look better before the deal is announced.
In the chart below, performance of the parent company’s stock is shown in blue. The spinoff is shown in green.
While the parent company performs well before the announcement, performance after the announcement is less noteworthy. After the spinoff is completed, the target company tends to move slowly with just a slight a gain, on average, three months after the transaction is closed. The parent company shows a loss, on average over this time. Between three and six months after the transaction closes, the parent company rebounds a small amount while the spinoff tends to deliver strong gains.
With just this data, we can develop some insights that could be useful for trading.
First, there is no benefit to searching for potential spinoffs. The stock tends to deliver gains before the announcement but performance is in line with the market average after the announcement. If you already own a stock when a spinoff is announced, it could be worth considering selling, You could always buy shares in the new company after the spinoff is completed.
In the days leading up to the spinoff, it could be profitable to buy a put option on the parent company. Put options give the buyer the right, but not the obligation to sell a stock at a predetermined price for a predetermined amount of time. Buyers of options never risk more than what they paid to buy the option. This strategy, buying a put, could benefit from the expected decline in the price of the parent company.
When the transaction is completed, it could be profitable to buy the new company. This strategy could benefit from the tendency of the newly issued stock to rise.
The chart above shows general averages. It’s possible to dig deeper into the data and develop a more refined strategy. A look at spinoffs focused on market cap shows that only one group of companies accounts for all the gains that occur after the spinoff. This can be seen in the next chart.
Spinoffs involving the smallest companies tend to deliver the strongest gains. Deals announced by companies with market caps less than $100 million deliver the best results. The parent company drops an average of 10% after the transaction is completed and the newly issued shares gain an average of more than 30% over that time. Based on the averages, these spinoffs should always be considered as potential trades when they are announced. You could find deals when they are announced with something as simple as a Google news alert for the word “spinoff” although that will result in many articles unrelated to upcoming transactions.
Another way to look at the data is shown in the next chart which shows performance based on whether or not activist hedge funds take positions in the parent company and push for a deal.
In these spinoffs, the parent company tends to deliver strong returns after the announcement. These will generally be large cap stocks and returns average 12% in just six months. After the transaction is completed, hedge funds seem to continue being an indicator of positive returns.
The research confirms what we have long known, which is that the potential rewards of spinoffs can be large. The study confirms another fact we have long known which is that detailed analysis is required to identify the best trading opportunities. As we saw, deals involving small cap companies tend to do better than deals involving large companies. However, this is not always the case. The involvement of activist hedge funds can boost the returns of deals involving large caps. But, this is true only when the right hedge funds are involved.
In other words, spinoffs provide opportunities for large gains. But, not all deals will be winners. We have been applying research to these opportunities for years. In fact, this is one of the techniques we use to identify stocks in Triple Digit Returns service. You can learn more about Triple Digit Returns at this web site,