Last Updated on 10 February, 2024 by Abrahamtolle
Do Spinoffs outperform the market? Is a spinoff a good or bad investment? A spin-off strategy seems to work well.
Evidence points out that spinoffs have historically been good investments, for both the company being spun off and the parent company.
This article explains what a spinoff is, why it outperforms, why it is good, and why a company would spin off part(s) of its businesses.
There are plenty of reasons why a company might choose to unload or otherwise separate itself from the fortunes of the business to be spun off. There is really one reason to pay attention when they do: you can make a pile of money investing in spinoffs. The facts are overwhelming. Stocks of spinoff companies, and even shares of the parent companies that do the spinning off, significantly and consistently outperform the market averages.
– Joel Greenblatt, You Can Be a Stock Market Genious
Joel Greenblatt points out in You Can Be A Stock Market Genious that spinoffs have historically outperformed the market. He presents several case studies to argue his case, but any investor should know that spinoffs are not a sure thing.
Like the rest of the market, the results are skewed to a few outliers that increase the average performance. The median spinoff performs worse than the market.
First, let’s start by explaining what a spinoff is:
What is a spinoff?
A spinoff is a dissolution of the existing company by separating one or more of the parent company’s subsidiaries. The spinoff is a new entity with its assets, employees, and resources where the parent company’s shareholders are allotted shares in the new entity.
The spinoff becomes a separate company on the exchange, and the shareholders can dispose of or acquire more shares.
A recent example of a spinoff is the elevator company Otis. From 1976 until March 2020, it was part of the industrial conglomerate United Technologies (now a part of Raytheon). Otis is currently an independent company listed on NYSE.
However, most investors like to know if a spinoff is good or bad. And most of the research, to our knowledge, tend to indicate that spinoffs outperform the markets, at least in the short and intermediate time frames, something we discuss further below.
Why does a company spin off a business?
There could be many reasons why a company would want to spin off its businesses. Below we list the most obvious ones:
Why would a company spin off some of its businesses? One reason might be the conglomerate discount.
Frequently the market value a diversified group less than the sum of its parts. For example, a conglomerate of four specific divisions might have a market cap of 100 billion. However, the market cap could be 125 billion if the four divisions were independent companies.
Thus, the shareholders are “rewarded”, at least in the short-term, by breaking up the company (or at least part of the company). This is called “unlocking shareholder value”.
An example of a conglomerate is Berkshire Hathaway. Many have argued it should spin off some businesses, but this is very short-sighted, in our opinion. Even though the sum of the parts most likely is worth more on its own, Warren Buffett’s magic is his capital allocations derived from the cash flows from the underlying businesses. Shareholders need to think long-term when they vote for spinoffs or not. Buffett can reinvest the retained earnings much better than you can.
There might be no buyers
When a conglomerate wants to get rid of a division but can’t find sellers at an acceptable price, a spinoff is the most straightforward course of action. In most cases, it’s easier to sell a division than to list it as a separate entity.
A smaller unit is easier to manage
The parent company’s management might not have the knowledge or the expertise to manage the relevant division. Thus it might be better to list it as a separate entity. Alternatively, management has less to focus on in a streamlined entity.
Lack of synergies
Some parts of the conglomerate might grow fast, while others grow slowly. Moreover, it might be little synergies between some parts of the business segments.
When management has to deal with different businesses, one might be a drag on the other. When there is no overlap, the companies are better managed separately than under one umbrella.
In Berkshire, various businesses can thrive because of the hands-off approach by Buffett. Buffett focuses on capital allocations, not managing the businesses, which are better left to the local managers.
Many companies are forced to split up their businesses: antitrust laws make spinoffs prevalent in industries with monopolistic tendencies or highly regulated.
Is a stock spinoff good or bad?
There is no exact answer to this question. Sometimes it makes sense; other times, it might result from short-term activists with no interest in the company’s long-term prospects. The four reasons above indicate that management needs to evaluate its pros and cons in each case.
One of the benefits is that a spinoff company might be easier to understand and analyze. A company that’s easier to analyze is, in most cases, valued at higher multiples. The sum of the parts, when they are separate, thus makes them more valuable.
Most of the evidence suggests that spinoffs perform better than the market:
Do spinoffs outperform the market? (Backtest)
Spinoffs outperform the market, at least in the short term. The Edge Group and Deloitte published a research paper in December 2014 called Global Spinoffs & The Hidden Value of Corporate Change.
Their survey looked at all spinoffs listed on an exchange on all exchanges in the Western world from 2000. The return one year after the spinoff is summarized in this table:
Rest of the world
The reference index is MSCI World for “Rest of the world”, the S&P 500 for the USA, and STOXX 600 for the EU. Both the parent company and the new entity outperform the market.
However, 40% of the spinoffs don’t show a positive return. Thus, the result is skewed to a relatively few listings that perform very well.
In a more recent study from 2017, done by S&P Global, the positive returns for the spinoffs are confirmed:
The returns are not immediate as the first month shows weak performance, but the result improves the longer the time horizon (up to three years). The parent companies, however, show mixed results.
In a recent article in Forbes, Jonathan Boyar argues spinoffs have underperformed over the last decade. He explains why:
- The growth in passive investing: Active investors have less capital available to buy shares of spinoffs causing shares to languish.
- Increased shareholder activism: Activists have been active, but the unintended consequence is that more low-quality businesses are spun off, resulting in weak returns.
- Pruning corporate deadwood: More companies are spinning off dressed-up units. This is good for the parent company but not for the new entity.
As you can see, as is always the case with the stocks market, nothing is written in stone.
To do well, you need to pick stocks – which is very challenging no matter the strategy you chose, as the famous study by Hendrik Bessembinder from 2017 reveals (Do Stocks Outperform Treasury Bills?).
Why do spinoffs tend to perform well?
The most likely reason is “unlocking” shareholder value. This is, in most cases, a short-term effect and might explain the low correlation with the overall market during the first year of listing. The new entity might increase its earnings multiple from 15 to 18, thus increasing value.
Likewise, the parent company might be valued more because it got rid of a business not desired by the market. In the short term, the most likely reason is valuation.
A business’s valuation is linked to its performance in the long term. We have not seen any studies that measure performance after three years, which would be very interesting.
Spinoffs outperform seem to be a good investment and tend to outperform, but markets go in cycles. No strategy performs well all the time, something that applies to spinoffs as well. However, the evidence suggests outperformance over time.
– What is a spinoff in investing?
A spinoff in investing is the dissolution of an existing company by separating one or more of its subsidiaries. Shareholders of the parent company are then allotted shares in the new entity, which becomes an independent company listed on the exchange.
– Is a stock spinoff a good or bad investment?
The evidence suggests that, historically, stock spinoffs have been good investments. They tend to outperform the market, at least in the short term. However, individual outcomes can vary, and careful consideration of each spinoff’s pros and cons is essential.
– How long does it take for spinoffs to show positive returns?
Spinoffs may not show immediate positive returns, with the first month often exhibiting weak performance. However, studies suggest that positive returns tend to improve over the longer term, up to three years after the spinoff.