Wednesday, 17 October 2012

Special Situations: Spin-offs

How to invest in
‘special situations’
  • Why I love company spin-offs and you should as well

Have you ever wanted to invest in a merger, acquisition, spin-off, or even a bankruptcy? It’s called special situation investing, and it can be a profitable way to take part in the stock market.
In many cases, special situations end up performing well because the businesses concerned have had a run of poor performance, and this has spurred management into drastic action to resolve the situation.
Spin-offs and other special situations are definitely high on our radar.

Spin-offs, the special situation of choice
I like all special situations, but spin-offs are my favorite. 
In this case I’m talking about corporate spin-offs, where a larger company decides to take a small part of its business, list it separately, and distribute the shares to current shareholders, such as the 1997 British Gas spin-offs, which gave birth to BG Group (LSE: BG), Centrica (LSE: CNA), and what is now National Grid (LSE: NG).
They don’t come along often, but I believe the potential returns make it worth investigating them thoroughly. For example, so far this year, the Bloomberg Spinoff Index is up 30%, and a 2010 report from UBS also showed that the 75 European spin-offs from the past decade outperformed Europe’s top 300 companies.

Why companies pursue spin-offs

There are many reasons a company might pursue a spin-off, instead of keeping a company in-house. One of the more common reasons is that the two businesses aren’t related, and very little is gained by keeping them under one umbrella and having them share capital.
I think the Primark retail group within Associated British Foods (LSE: ABF) is a perfect example of this, though ABF has repeatedly stated it has no plans to spin-off or sell the unit. In other cases, one division is considered a good business by the investment community, while another unit is considered an anchor or dead weight that slows the good business down.
Spinning a business off to shareholders instead of selling it is generally the more shareholder-friendly action. Arguments against a spin-off are because a business is too small to list, or lacks the management talent needed to run a publicly traded company, but in many cases taxes are the ultimate deciding factor. If a business has substantially depreciated assets, the tax hit can make a sale prohibitive for the company and shareholders, while a spin-off can often allow shareholders to realise the value of the business without triggering any tax payments.
Why spin-offs tend to do well
No two spin-offs are alike, and in some cases the larger parent may outperform the business being spun-off. But, in most cases, I find it is the smaller business that tends to outperform, but this can come with some initial volatility because shareholders often must tolerate an initial dip in the share price of the spin-off. Such dips might happen because large, institutional investors or fund managers have invested in the parent to gain exposure to the larger business, and have no interest in the smaller spin-off. In some situations, fund managers simply can’t own the spin-off, because they have limits on the size of companies they can invest in. So, as soon as the shares are received, they are sold off.
I reckon these types of situations only make spin-offs juicier opportunities for astute investors, but there are other signs to look for as well. High up on the list is a management team with incentives for growing the business, earning high returns on capital and, if you can find it, an ownership stake in the business at spin-off. Any time you can find these qualities, it becomes even more likely that management is going to take advantage of its newfound ability to allocate capital and grow the business without having to worry about their former corporate overseers.
Final thoughts
I’ve shared the basic reasons behind why spin-offs tend to outperform. But if you’re hungry for more information on spin-offs and special situations in general, I recommend the excellently written – though horribly titled – You Can Be a Stock Market Genius by Joel Greenblatt. The book provides a thorough look at a few spin-offs from the past and the clues investors were given in the filings that a unique opportunity was about to unfold.

From:  Motley Fool
12th October, 2012

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