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Why Spinoffs


rukawa
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I have read "You Can be a Stock Market Genius" about spinoffs but I never completely understood why they make sense and have never had one that made sense to me. I think the Greenblatt logic was that spinoffs make sense because the holders of spinoffs typically sell them which depresses their value. This is because the spinoff holders were not interested in holding a small company in the first place.

 

Have other people made significant money using this strategy. Are there things I should be looking for? Does it makes sense at this time given the high valuations for small cap stocks?

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That's only one possible reason. Other times the parent company can be undervalued as its true earnings power emerges. The general point is that spinoffs create confusion as investors have to decide which of the parts they want. The enterprising investor can do the work and see which parts are more attractively valued.

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I'd ask a different question, why do they even happen in the first place?

 

Ignore the market, think about working at a large company, why would a power hungry middle manager want to give up control over a portion of their company?

 

Here's my personal pet theory.  All companies that spin-off units think poorly of the units, if they didn't they'd keep them.  The executives at the company don't want this drag on their business anymore.  If you've worked in corporate America long enough this is definitely the raison d'être.  I believe the market reflects this, these executives are dumping what they don't want, and the market appreciates that and prices the stock accordingly.

 

The reason they work for investors is this.  Most of corporate America is bloated and full of inefficiencies that for structural/cultural reasons can't be eliminated.  So you get this division that's spun off, someone is now the CEO.  Their pride is on the line, they want to do well and make a name for themselves with this job.  Secondly there is a lot of fat they can cut that couldn't be cut in the past without affecting operations.  So you get an executive team that's charged up and makes cuts and changes that should have been made with the company was a division of the parent.  The company's results improve and the stock price rises higher.

 

The irony is that in many cases if the parent had made the changes that are made after a spin-off then they'd never spin-off the division.  But as anyone who has ever stepped into a conglomerate's office knows that rationality is not a basis for decision making.

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In most cases they exist because the parent companies can't sell them for the right or any price. Sometimes it's simply a way to sell a division tax efficiently. If you want to know whether they work you simply have to look at what John Malone has done for the last decade. Every single one of those Liberty spin-offs did very well.

 

However, not every spin-off works out – they work on average. You have to do your homework. But it's a very good place to start looking for cheap companies and I think this Greenblatt's message.

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I have read "You Can be a Stock Market Genius" about spinoffs but I never completely understood why they make sense and have never had one that made sense to me. I think the Greenblatt logic was that spinoffs make sense because the holders of spinoffs typically sell them which depresses their value. This is because the spinoff holders were not interested in holding a small company in the first place.

 

Have other people made significant money using this strategy. Are there things I should be looking for? Does it makes sense at this time given the high valuations for small cap stocks?

 

Personally, I don't think that spinoffs give you a huge edge.  In terms of growing intrinsic value, financial engineering rarely creates values.  The more interesting financial engineering situations happen where one group of people takes advantage of another group of people.  Sometimes this happens with spinoffs... mainly with John Malone.

 

2- I would just study Warren Buffett.  His track record is better than Joel Greenblatt's.  At least to me, it makes sense to invest within your circle of competence.  It takes a while to develop an understanding of an industry.  It took me a long time to really understand mining.

 

3- Warren Buffett did incredibly well in Berkshire Hathaway with zero spinoffs, very little in share repurchases, not that much tax avoidance, and very little financial engineering.

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On my side, I recently received spinoff shares NOW inc (DNOW)  from National OIlwell Varco.

This company is active in supply chain for energy sectors.

 

What is interesting is that the top management of the parent company has left this one to join the new spinoff.

This is an interesting move to follow.

 

I didn't check if they are some incentives for this management at the spinoff level but based on the historical success of acquisitation/aggregators at NOV level, I bet that the management could repeat the history at the spinoff level.

 

This spinoff has also been discussed with the name not revealed in the last quarterly letter of East Coast Asset Management.

 

Interesting situation from my point of view.

 

 

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For me Greenblatt, not Buffett, is the authority on this because of his track record in investing in special situations.

 

2- I would just study Warren Buffett.  His track record is better than Joel Greenblatt's. 

 

I don't think this is correct. Joel Greenblatt's public track record for the 10 years he had his hedge fund, which did exactly the type of investing he describes in You Can Be a Stock Market Genius, was 50.0% per year gross/40% net of incentive fees. I don't think that Buffett beats this in any 10 year period.

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On my side, I recently received spinoff shares NOW inc (DNOW)  from National OIlwell Varco.

This company is active in supply chain for energy sectors.

 

What is interesting is that the top management of the parent company has left this one to join the new spinoff.

This is an interesting move to follow.

 

I didn't check if they are some incentives for this management at the spinoff level but based on the historical success of acquisitation/aggregators at NOV level, I bet that the management could repeat the history at the spinoff level.

 

This spinoff has also been discussed with the name not revealed in the last quarterly letter of East Coast Asset Management.

 

Interesting situation from my point of view.

 

Thanks for putting a name to the East Coast spin-off.

 

Most other managers actually discuss their stocks by name unless there is a good reason not to...

;)

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To me it makes perfects sense that there is opportunity in Spin Offs.  Any spin off will create new securities and new capital structures, and potentially financials that are "not clean". 

 

There will be new sets of incentives as well.  With new management teams with new ambitions and goals.

 

There will be forced selling, where new equities do not qualify for certain funds (due to size/index/sector restrictions).

 

In such an environment a good analyst/investor has an opportunity to find outperformers.

 

That said, most MBA students are told to read "How to read a stock market genius" these days.  It's a great book.  There are even blogs and email newsletters dedicated to them.

 

So whereas in the 80s Greenblatt and a few others were the only people actively looking at spinoffs, now the universe is much larger.

 

Therefore, the market is more efficient than it was.

 

Comparing Buffett to Greenblatt is pointless, IMHO.  Completely different eras, market returns, opportunities, goals etc.

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Anybody encountered any of those mouthwatering greenblatt plays as of late? I recall reading about a special situation in 2008. I think JP morgan was gonna buy Bear sterns. And they accidently garuanteed all Bear's liabilities even if they would not buy them. And this was in the merger documents. So next day it was trading 2-5$, Morgan realized their mistake, and quickly bid 10$ for the whole thing within days I think. Those situations are just mouthwatering :). I don't think the art is in analyzing them, but you just have to find them.

 

I have not seen many interesting spin offs though. I think everyone is now looking at spin offs these days. So many hedge funds looking for long hanging special situation fruit.

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As Charlie says, "always invert", so instead of "why spinoffs?" your question should be...................actually, I'm not sure where I was going with that.

 

How about: "Why should these businesses be together?"

 

If you can't find a good reason, probably best to split them off.

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Anybody encountered any of those mouthwatering greenblatt plays as of late?

 

In July, you could have bought VRTV (IP spinoff) for as low as $32.50. It's at $47.25 today. 45% return in just over a month.

 

EGL when it was spun-off from LLL – this worked out great. LE/SHLD – still running (SHLD is several special situations in one stock). Later this year probably LINTA. Lots of activist investments result in spin-offs (e.g. McGraw-Hill or BKN). There are still great opportunities out there.

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Compared to other new stocks -- mostly IPOs, and many existing stocks, spin-offs (non-IPO types) lack the often present "promotional" premium. New management probably has incentives not to promote in the first few months, so this may contribute to later outperformance.

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sometimes there is forced selling of spin off. it may not be part of an index and index investors have to sell it. it may be too small to hold. it may not fit their criteria. it may be an insignificant position. it may not pay a dividend when your mandate is to own dividend payers. the best spin offs are actually very beautiful creatures--just designed to look ugly at first. 

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the most interesting spins to me are often the bad part of businesses or business units that the board at the parent has just given up on. Things like Huntington Ingalls or Fortune Brands H&S. Can come out at huge discounts to what the business is worth once you look through the nearer term issues.

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For me Greenblatt, not Buffett, is the authority on this because of his track record in investing in special situations.

 

2- I would just study Warren Buffett.  His track record is better than Joel Greenblatt's. 

 

I don't think this is correct. Joel Greenblatt's public track record for the 10 years he had his hedge fund, which did exactly the type of investing he describes in You Can Be a Stock Market Genius, was 50.0% per year gross/40% net of incentive fees. I don't think that Buffett beats this in any 10 year period.

 

Buffett's track record is very long and he is one of the richest people in the world.  I don't see Greenblatt putting up a similar performance when he hits Buffett's age.

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There can be "stock market reasons" why spinoffs can be good investments, and there can also be conventional business reasons.

 

The "stock market reasons" have to do with the trading in the stock and have been discussed (e.g., forced selling for funds with a mandate that doesn't allow them to hold, price insensitive selling for people who find themselves owning an insignificant position in the spin because of its small size relative to the parent, the spin will often be an "ugly" business compared to the parent).

 

The business reasons are varied, but one that would be pretty consistent across all spin-offs has to do with the new incentives that exist after the spin-off.  (I.e., the life/dinner principle--the rabbit runs faster than the fox because the rabbit is running for his life, while the fox is running for his dinner).  Say a company has two segments, with one business unit that amounts to 5% of its total sales and 2% of its total profit, while the other unit accounts for the remaining 95% of sales and 98% of profits.  And say the smaller unit is also in a declining industry.  Well, in that case the company is unlikely to expend much effort to improve the results of the smaller unit.  It simply wouldn't be very efficient to do so.  They would have to double profits at the smaller unit to have the same effect as increasing profits by only 3% at the larger unit.  And for management teams who get paid with stock options, the results of the smaller unit will have almost no effect on the total valuation of the company and its stock.  It's almost irrational for such a management team to work at all on improving the results of the smaller unit.

 

But once that smaller unit is spun off, the operations of that small unit now become of primary importance for the new management team (it becomes the rabbit's life, not the fox's dinner), and they have the right incentives in place because they will have stock options in the spinoff.  So this can lead to a real increase in the value of the spun off company that would not have happened had it remained part of the parent company. 

 

Another reason that you'll often see is regulatory/legal.  Sometimes because of regulatory or legal reasons, the spun off business can do better simply by not being a part of the parent company anymore.  An example is the LLL/EGL spin-off from a couple years ago.  The EGL business can basically be described as a temp/staffing agency that employs people with security clearances and contracts them out to the Dep't of Defense or other gov't agency(Edward Snowden worked for Booz Allen Hamilton, which is a similar company to EGL).

 

Margins for the EGL business are low and the cash flow characteristics are not good because (like many federal contractors) they carry a large receivables balance that is not offset by a similarly-sized payables balance (they have to pay their workers every 2 weeks, hence no real payables balance, but the gov't does not pay them until about 70 days later, hence the large receivables balance).

 

The parent company's main business--designing and manufacturing high-tech defense hardware--is a much "better" business on almost every metric, and was much bigger on an absolute basis. 

 

The regulation at issue here is the Organizational Conflict of Interest rule (OCI), which says that a company can provide one of the above services on a single project, but not both.  So before the spin, LLL could supply hardware to a certain project, or it could supply the people, but it could not do both.  The idea behind the rule is that if employees from a certain company work on a project, then they would have the incentive to steer purchases of hardware to that company, and that incentive might lead to bad outcomes. 

 

In practice, the hardware business always had priority because there was much more potential profit there.  So if the hardware business bid for the contract on a certain project, then the EGL business simply would not bid on that same project so as not to put the hardware bid in jeopardy.

 

By getting spun off from LLL, the EGL business was no longer subject to that constraint, and projects that previously would have been off-limits to them (because the hardware business was going to bid on it or was already working on it), could now be bid on.

 

(The SAIC spin was done for the same reasons.  But it was done a little over a year after the EGL spin was done and by that time the general rally had progressed to where it wasn't common to see spin-offs really sell off much.)

 

 

 

So there are the stock market reasons that might allow you to buy the stock cheaply, but there are often real business reasons why the spun off company is worth more as an independent entity.

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For me Greenblatt, not Buffett, is the authority on this because of his track record in investing in special situations.

 

2- I would just study Warren Buffett.  His track record is better than Joel Greenblatt's. 

 

I don't think this is correct. Joel Greenblatt's public track record for the 10 years he had his hedge fund, which did exactly the type of investing he describes in You Can Be a Stock Market Genius, was 50.0% per year gross/40% net of incentive fees. I don't think that Buffett beats this in any 10 year period.

 

Buffett's track record is very long and he is one of the richest people in the world.  I don't see Greenblatt putting up a similar performance when he hits Buffett's age.

 

No, Greenblatt is the authority here. Buffet's only identifiable track record dates back to the 60s.

 

Guys, what is your point? Nobody disputes that Buffett is a great investor. I don't dispute that he may be a better investor than Greenblatt and I know that Greenblatt talks about being Buffettized. And achieving high returns on billions instead of millions is simply another league – it's incomparable.

 

What you can't say, though, is that Buffett has the better track record, when there is no ten year period in which Buffett had better returns than Greenblatt managing similar amounts of money. Saying "spin-offs are bad investments because Buffett is the better investor" just doesn't make any sense. This is especially the case, because Greenblatt's 10 year track record is simply insane and – I know you don't want to hear it – he achieved it by investing in special situations and especially spin-offs. We're talking about the attractiveness of investing in spin-offs after all, aren't we?

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For me Greenblatt, not Buffett, is the authority on this because of his track record in investing in special situations.

 

2- I would just study Warren Buffett.  His track record is better than Joel Greenblatt's. 

 

I don't think this is correct. Joel Greenblatt's public track record for the 10 years he had his hedge fund, which did exactly the type of investing he describes in You Can Be a Stock Market Genius, was 50.0% per year gross/40% net of incentive fees. I don't think that Buffett beats this in any 10 year period.

 

Buffett's track record is very long and he is one of the richest people in the world.  I don't see Greenblatt putting up a similar performance when he hits Buffett's age.

 

No, Greenblatt is the authority here. Buffet's only identifiable track record dates back to the 60s.

 

Guys, what is your point? Nobody disputes that Buffett is a great investor. I don't dispute that he may be a better investor than Greenblatt and I know that Greenblatt talks about being Buffettized. And achieving high returns on billions instead of millions is simply another league – it's incomparable.

 

What you can't say, though, is that Buffett has the better track record, when there is no ten year period in which Buffett had better returns than Greenblatt managing similar amounts of money. Saying "spin-offs are bad investments because Buffett is the better investor" just doesn't make any sense. This is especially the case, because Greenblatt's 10 year track record is simply insane – and he achieved it by investing in special situations, of which he says spin-offs are his favorite. We're talking about the attractiveness of investing in spin-offs after all, aren't we?

 

I think the point is that some investors equate Buffett's wealth with god-like status.  If he's so rich then he must be the smartest person in the world, and if we must mimic his actions we'll all be as smart/wealthy/good looking as he will be too. 

 

For my money I'd say Greenblatt is the authority here.  He literally wrote the book on this stuff, he generated incredible returns then got out at the top and shifted his style.  Yes Buffett is richer, but I don't consider riches to equal authority, although most of America disagrees.

 

There are a LOT of little market niches, many of them will have insane profits laying in the bottom for those who choose to specialize.  I think the key is finding the niches and exploiting them, it worked well for Greenblatt.

 

A last thought, not everyone has this weird drive to have the most money in the world and work their entire life.  Some are happy with 'enough' and getting out of the game.  In some past interviews I read of Greenblatt that seemed to be the case with him, he had enough money and was tired of running a fund, dealing with investors.

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Not that it really matters and I like both Buffett and Greenblatt just fine without having to choose between the two, but if we could rerun history, I'd be curious to see how Buffett would have done with Greenblatt's starting AUM during the 1985-1994 period during which Greenblatt had his amazing run.

 

Buffett's famous "I guarantee you I could do 50%/year with small amounts" (which might actually mean it's what he was doing at the time in his personal account with small sums) during a nice steep bull market would be fun to see.

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For me Greenblatt, not Buffett, is the authority on this because of his track record in investing in special situations.

 

2- I would just study Warren Buffett.  His track record is better than Joel Greenblatt's. 

 

I don't think this is correct. Joel Greenblatt's public track record for the 10 years he had his hedge fund, which did exactly the type of investing he describes in You Can Be a Stock Market Genius, was 50.0% per year gross/40% net of incentive fees. I don't think that Buffett beats this in any 10 year period.

 

Buffett's track record is very long and he is one of the richest people in the world.  I don't see Greenblatt putting up a similar performance when he hits Buffett's age.

 

No, Greenblatt is the authority here. Buffet's only identifiable track record dates back to the 60s.

 

Guys, what is your point? Nobody disputes that Buffett is a great investor. I don't dispute that he may be a better investor than Greenblatt and I know that Greenblatt talks about being Buffettized. And achieving high returns on billions instead of millions is simply another league – it's incomparable.

 

What you can't say, though, is that Buffett has the better track record, when there is no ten year period in which Buffett had better returns than Greenblatt managing similar amounts of money. Saying "spin-offs are bad investments because Buffett is the better investor" just doesn't make any sense. This is especially the case, because Greenblatt's 10 year track record is simply insane – and he achieved it by investing in special situations, of which he says spin-offs are his favorite. We're talking about the attractiveness of investing in spin-offs after all, aren't we?

 

I think the point is that some investors equate Buffett's wealth with god-like status.  If he's so rich then he must be the smartest person in the world, and if we must mimic his actions we'll all be as smart/wealthy/good looking as he will be too. 

 

For my money I'd say Greenblatt is the authority here.  He literally wrote the book on this stuff, he generated incredible returns then got out at the top and shifted his style.  Yes Buffett is richer, but I don't consider riches to equal authority, although most of America disagrees.

 

There are a LOT of little market niches, many of them will have insane profits laying in the bottom for those who choose to specialize.  I think the key is finding the niches and exploiting them, it worked well for Greenblatt.

 

A last thought, not everyone has this weird drive to have the most money in the world and work their entire life.  Some are happy with 'enough' and getting out of the game.  In some past interviews I read of Greenblatt that seemed to be the case with him, he had enough money and was tired of running a fund, dealing with investors.

 

+1  I would add something, if there was something to add. 

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