Fact: over the three years following a spinoff, the spunoff company (on average) outperforms the S&P 500 by 10%. This is what a Penn State study found when they looked at the returns of spinoffs over 25 years.

To profit from this information we must learn why a spinoff outperforms the S&P 500. Further, if we can identify the factors that make a spinoff more attractive than other spinoffs, we can beat the spinoff averages, which means beating the S&P 500 by more than 10%.

First let's understand what spinoffs are and why they occur. A spinoff is when a parent company separates out one of its businesses and distributes shares in the new business to shareholders of the parent company. It is a tax-free transaction and if you owned shares, you still own the same percentage of the spinoff and the parent. However, now investors can buy and sell shares of the spinoff on its own.

Perhaps now you can understand some of the reasons for a spinoff. As Sara-Lee’s spinoff of Hanesbrands illustrates, sometimes unrelated businesses (underwear and food) are separated so that they can be better valued by the market. This spinoff also helped Sara-Lee meet its strategic goal of returning to growth (Hanesbrands has declining revenues). Sprint recently spunoff Embarq because it was a “bad” business for Sprint to be in. Sprint wanted to focus on the wireless industry and get out of the wired industry. In some cases, spinoffs are the only way a parent company can get rid of a business that nobody wants to buy. And finally, sometimes businesses must be spunoff for regulatory or antitrust reasons.

What we must remember is that spinoffs occur for a very specific reason: to create value for shareholders. Theoretically, companies are always trying to create value but inefficiencies in how they are valued and how they are run don’t always support this mission. Spinoffs are a way to address these ineffiencies.

But it gets better. Not only are spinoffs designed to create value but there are also factors that depress the stock price post spinoff, which increases the attractiveness of the investment opportunity. In many cases, people who bought shares in the parent company don't want to keep the shares of the spunoff company. They tend to sell, especially if the spinoff is a small part of the parent company and is an unrelated business. Mutual funds and index funds are often forced to sell the spinoff. This is because the spunoff company may not be part of the index and because mutual funds often have specific mandates that only allow them to invest in certain types of companies or industries. The spinoff may not meet these requirements.

Managers of the spinoff are empowered because they are now running a company in which they have a direct (and hopefully significant) equity interest. Additionally, the company is smaller, hopefully less bureaucratic, and more entrepreneurial. For these reasons the spinoff is usually run more efficiently.

Companies are often spunoff at cheap prices because there is no pricing process, unlike IPOs in which there are many parties involved in the pricing process. Spinoff prices are purely a function of the percentage of the parent company that the spinoff represents. In fact, management benefits from having the spinoff underpriced because their incentives are tied to share performance.

In summary, we have identified several factors that explain why spinoffs have average beating returns:

• The new company is often better run thanks to management incentives and entrepreneurial drive
• The new company is often underpriced because the parent was underpriced, which is often the motivation for the spinoff in the first place
• Unrelated factors such as forced selling reduce the price post spinoff

In the last year or so I have paid much more attention to spinoffs. The theory that spinoffs should ourperform the market makes perfect sense to me. The numbers back up this theory.

The ideas here are taken in part from a great book by Joel Greenblatt called "You Can Be A Stock Market Genius."

Further reading:

You Can Be a Stock Market Genius
Joel Greenblatt