Investing in spinoffs—and often their parent companies—can be a ticket to market-beating returns

SATURDAY, JUNE 1, 2013

Graduation Day for Spinoffs

By RESHMA KAPADIA | MORE ARTICLES BY AUTHOR

Investing in spinoffs—and often their parent companies—can be a ticket to market-beating returns. But not all are created equal: Four ways to play the recent crop.

The best parents know when their offspring are ready to go off on their own. And when corporate parents spin off parts of their business, it’s often the best thing for investors as well.

Graduation is in the air, and more companies are considering divesting businesses through spinoffs. Last month, industrial company Dover Corp. (ticker: DOV) said it planned to spin off a fast-growing consumer electronics unit. Two media conglomerates—Time Warner (TWX) and Barron’s parent News Corp (NWS)—have announced splits that separate their publishing units from other media properties. And a wave of corporate activism is pushing other executives to consider such moves. While PepsiCo (PEP) has fended off calls to split its snack and drink business in the past, Chief Executive Indra Nooyi said in April that the company is exploring “sensible opportunities to unlock incremental value through meaningful structural alternatives,” amusingly dense corporate jargon that kicked off spinoff speculation.

A good parent company knows when it’s time to let a fledgling business fly solo. And savvy investors know those new companies are good buys.The goal, of course, is to unlock the value of businesses that may have been obscured or not run as efficiently inside a conglomerate. (Another example isLeucadia National‘s February spinoff of its wine business, see “In Vino Veritas.”) “Spinoffs are usually good businesses that just need some air,” says Kimberly Scott, a portfolio manager of the $3 billion Ivy Mid Cap Growth fund.

Fifteen spinoffs have hit the market this year as of the end of May, 50% more than in the same period last year. What’s more, the $130 billion market value of this year’s crop is significantly higher than the $53 billion the 10 spinoffs in the same period last year were worth, according to Chicago-based research firm Spin-Off Advisors.

Clearly, investors are doing well. In the past year through May 30, the Bloomberg Spin-Off Index, which tracks spinoffs with a market value of at least $1 billion, is up 60%–more than double the 26% returned by the S&P 500. That outperformance isn’t limited to the spinoff, either—the parent company also usually sees a boost in share price. Credit Suisse looked at the performance of both the parent companies and spinoffs from 1995 to mid-2012, and found that the parents outperformed the S&P 500 by 9.6% and the spinoffs outperformed by 13.4% in the first 12 months after the separation. Other studies have shown that the outperformance tends to last 24 to 36 months, as both sets of management are better able to allocate resources, and pursue deals that may have been off-limits before. Another benefit: These newly focused companies make attractive takeover targets.

Valero Energy (VLO), for instance, spun off its gas station and convenience-store unit, Corner Store, now known as CST Brands (CST), on May 1, freeing an operation that got little attention and minimal resources inside the oil refiner. Now, CST management has the equity incentives and control needed to improve ho-hum margins and merchandising. Plus, since shareholders in the $22 billion Valero have little reason to own a small, specialty retailer selling beer and beef jerky at gas stations, they may dump their CST shares, giving other investors an opportunity to buy CST on the cheap. CST shares currently trade at 12 times 2014 earnings. If it trades closer to its peers at 15 times earnings, its shares could rise to $40 from their recent $31. “If there was a class in college called Spinoff 101, this would be a classic exhibit,” says Louis Meyer, a special situations analyst at Oscar Gruss & Son, who thinks “orphaned” spinoffs like CST can rise 20% to 50%.

ANOTHER OPTION IS buying the parent company before the spinoff happens.Ingersoll-Rand (IR), for instance, plans to spin off its security business, its most profitable operation and home to brands like Kryptonite, a maker of locks for scooters, bikes, and ATVs, and Schlage, best known for door locks. Prior to a spinoff, the parent company often trades at a valuation that reflects a sum-of-the-parts assessment of all its businesses: For Ingersoll-Rand, that should lead to a $67 stock, 16% above its current price of $57. Since the spinoff isn’t expected until the end of the year, further gains could come from what will become Ingersoll’s core business of heating and air-conditioning systems and pumps, as the recovery in housing continues.

Ingersoll-Rand’s spinoff will be a tax-free transaction, with Ingersoll shareholders getting a stake in the new company. Such “pure” spins are more common, and often preferred to businesses that are carved out and taken public separately, because they aren’t accompanied by a roadshow used to drum up attention. But some carve-outs are attractive, such as Safeway‘s (SWY) Blackhawk Network Holdings (HAWK) gift card and prepaid payment network business in April. The business had been one of Safeway’s most profitable, and the company has a major edge over rivals with its gift cards available in 100,000 retail locations, including 90% of grocery stores. Its “Go-Wallet” platform integrates gift cards with mobile applications, positioning it well for increasing smartphone use.

For investors who want a diversified approach, the Guggenheim Spin-Off ETF (CSD) holds stocks that were broken off in the past 30 months. It’s small—just $155 million in assets. But its average market value of $1.9 billion includes smaller spinoffs. Those tend to be more attractive than larger names already familiar to investors and analysts, says Joe Cornell, the head of Spin-Off Advisors.

The ETF has returned 24% annually over the past three years, putting it in the top percentile of its Morningstar category, and its 0.65% expense ratio is much lower than active funds that are tapping this theme. “It’s crushed the market, even after you adjust for risk,” says Matt Hougan, an executive vice president with IndexUniverse.

Three Ways to Play Spinoffs

Spinoffs tend to outperform the broad market for up to three years, but don’t ignore the parent’s stock. Three good options are below.