Investing in Spinoffs: The Road Less Travelled

A significant portion of investment returns stems from select events, and spinoff investing provides investors with those valuable opportunities to capitalize on. For anyone aiming to achieve substantial success in the markets, overlooking spinoffs is not an option.

Thoughts from some of the finest investors on special situations investing.

“If you spend your energies looking for and analyzing situations not closely followed by other informed investors, your chance of finding bargains greatly increases. The Trick is locating those opportunities”

-          Joel Greenblatt

Special situations are happy hunting grounds for the simon-pure analyst who prefers to deal with the future in terms of specific, measurable developments rather than general anticipations.

-          Benjamin Graham

Even Charlie Munger pointed out investors to carefully study spinoffs to generate high returns due to their high base rate of success.

To give some more evidence why spinoffs are a great hunting ground for investors, consider this study by SBI Capital. Where they analyzed 154 spinoff transactions in India during the 2002-2016 period and showed how it had beat the broader market indices hands down. The study concluded spinoffs generating an average excess return over the market index of around 36% Link

If you are convinced that there’s lot of value to study spinoffs, let’s get started.

What is spinoff?

So, imagine you have a big toy store that sells all kinds of toys. Now, one day, the owners of this store decide to take one section of the store, let's say the section with board games, and turn it into its own little store. That's a spinoff!

So, instead of all the toys being in one big store, now you have two stores: the original big one and the new smaller one that sells only board games. They're still related, but now they're separate. That's what a spinoff is all about - creating something new and independent from a bigger thing.

Another example would be that of a relationship between a father and son. When the son is in school, the father takes care of him, drops him at school, or takes him to his sports classes. When he grows up, the son goes to a new place for his higher studies, lives on his own, and becomes independent. That’s a spinoff. Similarly, in the world of business, management spins off unrelated or related businesses with different growth stories to unlock value.

Why does a spinoff happen?

Expanding on the previous example of a father and son, a son needs to leave his home so that he can independently experience life and focus on his ambitions. Similarly, when a division within a large company becomes mature and capable, it needs to be separated for better outcomes

Now let’s move on to what experts have to say, Greenblatt points out five reasons why a parent may spin off a subsidiary:

1. There is a concept known as “conglomerate discount”. By separating unrelated businesses it can unlock value. 

2. To separate bad business from a good business

3. To realize value for a subsidiary that can’t easily be sold.

4. To save on tax, as demerger is a tax-free transaction while selling the unit would create a large tax bill.

5. To resolve a regulatory hurdle. For instance, a company may be in the process of being acquired, It may need, however, to spinoff a subsidiary to address antitrust concerns.

Next, Greenblatt explains how to pick the best spinoff opportunities and shares the characteristics he looks for:

1. Institutions look to sell: During the initial weeks and months of trading post-listing the spinoff entity, there remains selling pressure on the institutions that cannot hold the new stock in their portfolio due to some rigid institutional mandates, such as being allowed to invest only in certain sectors or having limited exposure to certain sectors. You often end up with sizable paper losses in this case. This is exactly the time to invest in these opportunities as institutions are selling in desperation and not due to change in fundamentals.
   

2. Incentive for insiders: The greatest spinoffs are the ones which incentivize their managers along the same lines as shareholders. Will they receive a large part of their compensation in stock or options? Is there a plan for them to acquire more? These are some of the questions you need to ask before taking the bet.
   

3. Opportunity that was untouchable before: Before a spinoff, when two divisions or brands were under the same company, it was not possible to invest in them individually. However, after a spinoff, an investor can take positions in either the parent or the spinoff, giving an opportunity to create lucrative returns. Therefore, an investor needs to study both the parent and spinoff as opportunity might lie in any of the entity or sometimes both.

If you want to study spinoffs in India, study the entire process involved. An investor is rewarded just for his patience for procedural formalities to get completed.

A demerger process in India typically involves a sequence of six steps: (a) board Approval (b) stock exchange approval (c) secured and unsecured creditors and shareholders approval (4) NCLT final approval (5) record date of announcement by the board and (6) listing of the demerged entity

Great investors like Peter Lynch, Seth Klarman, Joel Greenblatt, and many more have discussed spinoffs in detail in their past works. Will cover some of them next time.

Some of the resources I have gone through which helped me write this article:

1. Gautam Baid, Joys of compounding

2. Peter Lynch, One up on wall street

3. Joel Greenblatt, You can be a stock market genius   

This article is for information purposes only, and not to be considered as investment advice.

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PS: We can delve into the case study of Mirza International, one of my investments that yielded a 7x return on my capital within ~2 years, at another time. 

Contributor: Nayan Goswami