From time to time, companies set up one or more of their divisions or subsidiaries as an independent company, then hand out shares in that company to their own shareholders, as a special dividend or “spinoff”.

Many investors seem to view spinoffs as a nuisance, because they leave you with a tiny holding in a stock you didn’t choose and that you know little about. As a result, these investors may dump any spinoffs they receive as soon as they get around to it. But looking for the advantages in a spinoff is a much better investing strategy.

As a general rule, you’d be better off to buy more of any stock you receive as a spinoff, rather than selling. In fact, a number of studies have shown that after an initial adjustment period of a few months, spinoffs tend to outperform groups of comparable stocks for several years.

A good example is the spinoff executed by NCR Corp., once known as National Cash Register and now one of the leading makers of ATM machines. In 2007, NCR (symbol NCR on New York) spun off its data warehousing business Teradata (symbol TDC on New York). Since the spinoff, the shares of Teradata are up 184%.

For that matter, the parent companies that do the spinning-off tend to outperform comparable companies for several years after a spinoff.

Needless to say, the general pattern doesn’t appear every time. Spinoffs and their parents sometimes run into unforeseeable woes. However, human nature makes it a good bet that both the parent and spinoff will prosper.

Why it pays to follow the lead of the value seekers

The first reason for the prosperity of spinoffs is simply that the managers of companies naturally prefer to acquire or expand their assets, not get rid of them. Getting rid of assets reduces a company’s total potential profit, and this reduces the funds it has available to pay its managers. The management of a parent company will only hand out a subsidiary company to its own investors if it’s fairly confident of being more prosperous after the spinoff than before.

Second, spinoffs involve a lot of work and legal fees. The parent will only spin off the unwanted subsidiary if it can’t sell the stock for what it feels it’s worth.

In one sense, a spinoff is the antithesis of a new issue. Companies sell new issues to the public when they feel it’s a good time to sell. They do spinoffs when they feel it isn’t a good time to sell, and that probably means it’s a good time to buy.

When a spinoff begins trading, it stands to reason that investors will put a low price on it. After all, the spinoff hits the market with a large number of neutral if not reluctant stockholders who have limited expectations for it, and who are willing to sell when they get around to it. Initially there is little if any brokerage research available on the company.

The only investors who might be willing to buy a new spinoff are value-seekers who have taken the trouble to read the voluminous material that companies hand out as part of the spin-off process. On the whole, it pays to follow the lead of these value-seekers. But you should only do that if you have the patience to hang on through months of sluggish trading, while reluctant spinoff holders exercise their urge to sell.

COMMENTS PLEASE—Share your investment experience and opinions with fellow TSINetwork.ca members

Have you ever received shares for a spinoff from a stock you owned? Did you sell the shares or keep them? Did you buy more shares over time? Do you still own the stock? Let us know what you think in the comments section below.