Spin-offs are a popular corporate action that company management and boards may pursue to unlock value or narrow down their focus. Many famous investors, such as Joel Greenblatt, Seth Klarman, and Charlie Munger, have voiced their support for spin-offs as sources of investment ideas. In this article, we look at how a spin-off trading strategy has performed historically.
A spin-off trading strategy has historically outperformed the market by a wide margin. A spin-off is the creation of a separate, independent company or entity from an existing parent company by distributing its assets, subsidiaries, or business units to its shareholders. But how do they perform in the long-term?
What is a spin-off?
A spin-off refers to the process of creating a new, separate company or entity from an existing one by divesting or separating a portion of the original company’s assets, operations, or subsidiaries. This is typically done by distributing shares of the new entity to the original company’s shareholders. The new entity becomes an independent, standalone company with its own management, financial structure, and ownership.
Spin-offs are often carried out for various strategic reasons, including:
- Focus: The parent company may want to focus on its core business operations and divest non-core assets or divisions through a spin-off.
- Unlocking Value: By separating a specific business unit or subsidiary into a new company, the parent company may aim to unlock the value of that unit, making it more appealing to investors and potentially increasing its market value.
- Strategic Realignment: A spin-off can help realign the corporate structure to better match strategic goals and market conditions.
- Access to Capital: The spin-off entity may have better access to capital markets, which can be important for its growth and development.
Spin-offs can take various forms, such as the distribution of shares to existing shareholders, the sale of the business unit to new investors, or a combination of both. The success of a spin-off depends on various factors, including the management of the new entity, its financial health, and its ability to operate independently.
Investors often receive shares in the new company when a spin-off occurs, and they may choose to hold or sell these shares based on their investment strategy and the prospects of the newly created entity.
However, what typically happens is that investors dump the stock of the new company disregarding its value, as they are generally labeled as the bad part of the parent company. Joel Greenblatt said it best:
“The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people. Generally, the new stock isn’t sold, it’s given to shareholders who, for the most part, were investing in the parent company business. Therefore, once the spin-off shares are distributed to the parent company shareholders, they are typically sold immediately without regard to price or fundamental value.”
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So, if spin-offs are so good and generate high returns, how do they perform in the long run?
Spin-off trading strategy and performance
According to research conducted by J.P. Morgan, spanning from 1985 to 1998 and encompassing 231 spin-off and carve-out cases, it was revealed that within the initial 18 months of trading, spin-offs demonstrated a remarkable outperformance of 11.3% over the S&P 500, while carve-outs exceeded it by 10.1%.
In another analysis of spin-off performance conducted by Credit Suisse from 1995 to 2012, they found that spin-offs outperformed the S&P 500 by an impressive margin of 13.4% during the initial 12 months following the spin-off date.
Spin-off trading strategy backtest
We can also analyze the returns of the Bloomberg U.S. Spin-off Index vs. the S&P 500. From 2003 to 2018, the Bloomberg U.S. Spin-off Index compounded at a 16.3% CAGR, outpacing the 9.3% CAGR of the S&P 500.
Although the Bloomberg U.S. Spin-Off index does not trade publicly, there is one ETF that attempts to do so: the Invesco S&P Spin-Off ETF (Ticker: CSD). Despite only having $55 million in net assets, it has been around for a long time. The ETF tracks the S&P spin-off index. The index tracks companies that have been spun off from larger corporations in the past four years. It is calculated using the total return, which includes dividends paid. The index and the fund are rebalanced every month.
Here is the equity curve since inception vs. the S&P 500:
The ETF compounded money at a 6.17% CAGR, compared to 9.20% for the S&P 500. The return is not as impressive as other research has shown, but this doesn’t mean that spin-offs don’t work.
Spin-off trading strategy – conclusion
In summary, spin-offs are a great source of returns for investors. Due to the nature of the transaction, indiscriminate selling by existing investors can create a short-term opportunity to buy stocks of excellent companies at depressed prices. As we have seen, they have consistently outperformed the market by a wide margin over the last few decades, making them a great choice for long-term investors.