Spin-Offs Often Beat the Market

What do  Moody’s (MCO),  Coach (COH), and  Zimmer Holdings  (ZMH) have in common? After all, one rates bonds, one sells luxury goods, and one makes orthopedic devices. However, all three are wonderful businesses that could have been purchased for very reasonable prices for the same simple reason--all three were spun off from larger companies, and spin-offs are, in my humble opinion, one of the few major market inefficiencies still out there. (For the curious, Moody’s came out of  Dun & Bradstreet , Coach from  Sara Lee , and Zimmer from  Bristol-Myers (BMY).)

There have been some academic studies of spin-offs that validate what I’ve seen anecdotally over the past several years, which is that spin-offs typically have a better chance of outperforming the market than the average stock. Not every spin-off is the home run that these three have been--and not every spin-off is a wonderful business--but you can make plenty of money buying decent businesses at wonderful prices, even if wonderful businesses at decent prices are more your cup of tea.

So, why are spin-offs often available at bargain prices? For a number of reasons:

No Hype
First, and most important in my mind, is that spin-offs don’t receive much publicity or hype. In stark contrast to IPOs, there’s no brokerage firm pumping up the stock, and so the initial trading price isn’t set by an auction-like mechanism that results in an “all the market will bear” valuation. Spin-offs just quietly show up in the accounts of people and institutions who own the parent company--and these owners frequently don’t know what to do with the stock, which leads to the second reason that spin-offs are often undervalued.

Selling Pressure
Many stockholders who receive shares of a spin-off tend to sell the shares shortly after they receive them. Index funds that own the parent have to sell almost immediately, because the spin-off is usually not in the index being tracked. Individuals and other institutional owners often sell because they don’t have the time to research the new company, or because it throws off their industry weightings.

Low Analyst Coverage
This is related to the “no hype” point, since having fewer analysts talking up the stock through their institutional sales forces can keep a temporary lid on valuation. I remember Moody’s had only a handful of analysts covering it even six months after it had come to market. It takes a while for the Street to begin covering spin-offs because they’re usually smaller firms, there was no IPO to drive commissions, and because--let’s be blunt here--the odds that the spun-off company will need investment-banking services are relatively low, since it has just started existence as a stand-alone entity.

Limited Track Record
Spin-offs have a limited operating history, which means there’s relatively little for a money manager to look at as a benchmark for future performance. Moreover, the track record that does exist is likely to be muddy and unimpressive, since the parent firm has a strong incentive to clean up its own books by allocating lots of “gray area” costs to the spin-off. With a limited and often unimpressive operating history, expectations for future performance are relatively low, which again tends to lead to a lower valuation.

Poor Initial Operating Performance
Oddly, the management teams of spin-offs often have an incentive to hold off on making major improvements in the business for the first year or so. Why? Well, they want their first batch of options in the newly independent firm to be granted at a relatively low price, which leaves more room for upside. It’s often surprising to me just how much cost some management teams are able to take out of spin-offs after the companies have been trading for a year or so. Somehow, getting that first annual grant of options makes them much more attentive to areas where fat can be cut.

That’s a long laundry list of reasons why spin-offs are often cheap when they first come to market. Notice, however, that every single one is temporary, and most have nothing to do with the underlying intrinsic value of the business. The hype will pick up if the company performs well, the selling pressure will abate as inattentive shareholders of the parent finish dumping the spin-off’s shares, analysts will eventually pick up coverage, the company will develop a track record, and management generally finds a way to improve the business dramatically after the first year or so. The result is improved cash-flow generation and sometimes a bit of valuation improvement as well, which often means a nicely appreciating stock price.

Lucky for you, there are a number of spin-offs set to come to market later this year. Here’s a partial list:  Motorola (MOT) will be dumping “Freescale,” its awkwardly named semiconductor business;  Viad (VVI) will be spinning off its Moneygram unit (and depending on the price, the “stub” Viad could be cheap enough to be interesting as well);  General Electric (GE) will be getting rid of a bunch of insurance businesses under the “Genworth” moniker;  ACE (ACE) will be spinning out some financial-guaranty businesses;  Abbott Labs (ABT) is getting rid of its Hospira hospital-supply unit; and  Kimberly-Clark (KMB) is talking about spinning off some paper and pulp operations.

Keep an eye out for these, and you may very well have a bargain on your hands--and bargains seem to be in short supply right now.

Shameless Plug
Morningstar's first full-length book on stock investing is out--look for it in your favorite bookstore, on BN.com, on Amazon.com, or right here on Morningstar.com. It's titled The Five Rules for Successful Stock Investing, and it was written by yours truly in conjunction with Morningstar's stock analyst staff. The first half of the book covers the basics of fundamental analysis: Developing an investment philosophy, a mercifully short introduction to reading financial statements, a primer on valuation, and a guide to evaluating company management and assessing economic moats. The second half is a series of chapters on each sector of the market--from hardware to health care to banking--that explains industry jargon and helps you analyze complicated companies.