3 Easy Steps to an Unusual Investment “Guarantee”

 

This is probably my favorite special situation of all for its simplicity.

Joel Greenblatt wrote about it in his 1997 book You Can Be a Stock Market Genius. Greenblatt, at that time, was a relative unknown. But his Gotham Capital had put up 50% average annual returns for 10 years. The book had a big impact on how I think about investing.

What are we talking about? Spinoffs…

A spinoff is simply when one company takes a part of its business and makes a formal separation with the parent company by creating a new, free-standing company.

You don’t have to own the parent to the get spinoff. It’s just that the shareholders of the parent get the shares automatically. You can pick up shares after a spinoff.

Spinoffs as a group have a tendency to beat the market. There have been a number of studies on this point. The most famous might be a Penn State study that showed spinoffs outperformed the market by about 10% per year in the first three years of independence.

That’s a huge edge!

Why does this happen? I think the best explanation is simply rooted in the nature of business. When a smaller group is freed from the parent, there are creative and entrepreneurial energies released as well. There is a management team that can now focus on the spun-out assets alone, without worrying about what the parent thinks or needs. There is some benefit from this focus and freedom.

So spinoffs are one of those pools of investing ideas I routinely fish in for new ideas. The amazing thing is that despite all the publicity and studies, the anomaly persists! Why? Well, as Greenblatt says, it’s practically built into the system. “The spinoff process is a fundamentally inefficient method of distributing stock to the wrong people.”

After all, people didn’t ask to invest in the spinoff. They didn’t choose to buy the shares. They bought shares of the parent, not the spinoff, which were given to them. So they tend to sell the spinoff. This is what usually happens. And all that selling pressure drives down the shares.

The spinoff, too, is usually a small piece of the parent — maybe 10%, often less. So if you have $10,000 in a stock, you get maybe $500 of this other stock. Rather than bother with it, you just sell it. Institutions do this, too. Instead of spending resources trying to figure out this new thing, they just get rid of it.

As Greenblatt writes: “Does this practice seem foolish? Yes. Understandable? Sort of. Is it an opportunity for you to pick up some low-priced shares? Definitely.”

Why do a spinoff at all then? Each case is different. Sometimes it is a way to get rid of a business that is tough to sell on its own. Tax reasons might enter into it. Or it might solve some other strategic objective. The most-common reason is to create shareholder value with greater transparency. The hope is that the market might appreciate the separate businesses more fully.

One example is General Growth Properties. Spinning out Howard Hughes was a way to package all of its development assets into one company so it could focus purely on running malls. Howard Hughes owns a hodgepodge of planned communities and things unrelated to malls. As a separate company, Howard Hughes can devote its full attention to its development assets. It’s a win-win.

Greenblatt offers a simple three-point checklist to search for winners. Howard Hughes met all three:

■ “Institutions don’t want it.” I can tell you there was no interest in Howard Hughes from institutions. Even now, there is little interest in the company. It still has no Wall Street coverage, for instance. It doesn’t fit it any of Wall Street’s boxes. It’s a hodgepodge of real estate with uncertain cash flows, neither fish nor fowl.

■ “Insiders want it.” By contrast, insiders loved Howard Hughes. They bought shares. Brookfield was among the big investors here and still owns 6% of the stock today.

■ “A previously hidden investment opportunity is created or revealed.” Buried in GGP, Howard Hughes assets could easily be ignored and overlooked. But on its own, with attention and capital, Howard Hughes can advance projects and unleash their potential.

Howard Hughes traded independently on Nov. 10, 2010. It went down after the first week of trading. But by April 2011, it had nearly doubled. Even if you had held the shares from the spinoff to now, you’d be up 25%, versus 5% for the market as a whole.

That’s why you should always pay attention to spinoffs…