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Stepan Lavrouk
Stepan Lavrouk
Articles (546) 

Seth Klarman: Areas of Opportunity, Part 2

Why value investors should become comfortable with spinoffs

May 18, 2020

Last week, I wrote an article about catalysts, which are events that can cause the market to reappraise underpriced value investments, as an area of opportunity. An example of this is when a biotechnology company receives FDA approval for a drug, but there are many others.

The possibility of a catalyst occuring creates an opportunity that value investors can exploit. In his book "Margin of Safety," Seth Klarman (Trades, Portfolio) discusses a number of other areas of opportunity. In this article, we will look at investing in spinoffs.

What is a spinoff?

A spinoff occurs when a parent company sells or distributes the shares of a subsidiary and creates a new, independent business. This usually (though not always) happens when the spinoffs are believed to be worth more as separate companies than as part of the "parent" company. Other reasons for spinoffs include when the "child" company has suffered some reputational damage, is involved in legal issues, is unprofitable or operates in an unpredictable market environment.

Klarman points out that a spinoff can often result in the shareholders of the parent company wanting to get rid of their new spinoff shares as fast as possible. If the parent went through the process of ridding itself of a subsidiary, then why should shareholders want to hold on to it? After all, isn’t management best placed to determine whether a part of their business is worth holding on to?

Such concerns are sometimes valid, but they ignore the reality that sometimes, a company can be less than the sum of its parts. In these cases, a spinoff can end up being a more successful business when allowed to stand on its own legs. Even if this is a case where the parent is shedding dead weight, that dead weight often still has more value than anticipated and can be mispriced.

Causes for spinoff mispricing

Why might a spinoff be undervalued? For one, the parent shareholders might interpret the fact that a spinoff is happening as a warning sign, which makes them willing to sell at prices below intrinsic value. In other cases, the spinoff may simply be too small for large institutional shareholders to bother with; why waste valuable analyst time calculating the real value of a microcap spinoff when it is easier to sell it and move on, especially when the spinoff might be in a different industry than the parent company? Index funds almost always sell their spinoff shares because their mandate prohibits them from holding companies that are not part of the index, and the same is true of some pension funds that track indexes.

Klarman also explains that it is sometimes in the interest of the management of these businesses to not publicise their true value:

“Management often receives stock options based on initial trading prices; until these options are granted, there is an incentive to hold the share price down. Consequently, a number of spinoff companies make little or no effort to have the share price reflect underlying value.”

In short, there are many reasons why a spinoff might be undervalued, and investors need to be on the lookout for them. This is not easy. Having to do research into small, obscure businesses is hard enough, and the spinoff process does not make it any simpler. However, these situations often contain the best bargains, and value investors like Klarman have done very well by specialising in them.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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