“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 (Trades, Portfolio)
Chapter three of “You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits” is lengthy one, dealing with the subject of corporate spinoffs. Author Joel Greenblatt (Trades, Portfolio) defined a spinoff as an event in which a company divests a subsidiary, division or some part of its business and converts it into new, independent company. This new company will be freestanding, with its own management and shareholders.
Why would a company sell off a part of its business? There are several potential reasons:
- Both parts of the business are expected to increase in value because the existing structure frustrates investors who are trying to understand or value it. This is particularly true in the case of conglomerates.
- A parent company wants to cut off a “bad” business to leave only a “good” business.
- Getting rid of a business that no other company wants to buy.
- Tax considerations; a well-structured spinoff allows shareholders to gain value without being taxed on the gain.
- It may address a strategic, antitrust or regulatory issue.
Greenblatt argued that spinoffs can be very good investments: “Luckily for you, the answer is that these extra spinoff profits are practically built into the system. The spinoff process itself is a fundamentally inefficient method of distributing stock to the wrong people.”
What he means is that spinoff stock is usually distributed to existing shareholders, rather than sold on the open market. Since shareholders still hold stock in the parent, they tend to sell shares of the spinoff right away without giving much thought to the spinoff’s price or fundamental value. A lot of shares are dumped onto the market, creating an excess supply and depressing the price.
Institutional investors, in particular, are likely to sell their spinoff holdings since the share price may be too low to meet their criteria, or because the spinoff is not included in the S&P 500 Index.
Spinoffs may also release management’s entrepreneurial drive, a drive that may have been held back by the parent company. Simply put, organizations that escape the reins of a parent can be more successful than they were in confinement.
The third reason why spinoffs are inherently good investments is because management believes in increasing shareholder value; not infrequently, that follows unsuccessful mergers and acquisitions.
Greenblatt went on to claim that while most spinoffs are likely to be good opportunities, some are better than others. Fortunately, he wrote, “You don’t need special formulas or mathematical models to help you choose the really big winners. Logic, common sense, and a little experience are all that’s required. That may sound trite but it is nevertheless true.”
To illustrate, he went on to deliver case studies that profiled the experience of several companies and their spinoffs, beginning with the Marriott hotel company (this book was published in 1999, so the action took place more than two decades ago).
In the early 1990s, Marriott Corp. had a big problem. It had built hotels rapidly in the 1980s; once completed, the hotels were usually sold, but Marriott continued to collect management fees for them. But economic conditions had changed, and the company was left holding the bag on many hotels that could not be sold and stuck with billions of dollars in debt.
Financial consultant Stephen Bollenbach was recruited to deal with the situation. His solution was to spin off the management-contract business with its substantial income stream, but little in the way of hard assets. This would mean putting the company’s unsold hotel properties and all its debt into one company—the “bad” one—which would be called Host Marriott (HST, Financial). The other company—the “good” one— would get the management services business, which had little debt and would be known as Marriott International (MAR, Financial).
While most investors would be attracted to the good company, Marriott International, Greenblatt was excited about the bad company, Host Marriott. He had several good reasons:
- Most institutional managers would dump their Host Marriott shares because the new stock would be priced below $10, and he expected shares to be available at highly discounted prices.
- Insiders were sticking around; Bollenbach would become its CEO and the Marriott family would hold a 25% stake in it.
- An opportunity, previously unknown, would be created or revealed. In this case, it was “tremendous leverage.” Greenblatt calculated that if the company was successful, as he expected, a 15% increase in the value of Host’s assets could produce a doubling of the stock price.
He added, “Believe it or not, far from being a one-time insight, tremendous leverage is an attribute found in many spinoff situations… Every dollar of debt transferred to the new spinoff company adds a dollar of value to the parent.”
With this information, all available from public sources, Greenblatt believed he had built a viable investment theory for investing in Host Marriott, the bad company.
Indeed, that bad company turned into a good investment for Gotham Capital, his investment vehicle: the share price of Host Marriott almost tripled in the first four months after the spinoff.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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