Spinoff investing has been proven to generate above-average returns—and part of that comes from their takeover appeal.

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. For that matter, the parent companies also tend to outperform comparable firms for several years after a spinoff.

Spinoff investing: why it’s most often a winning strategy

A spinoff takes place when a company decides to get rid of a portion of its asset base, possibly because it wants to focus its activities elsewhere, but is unable to sell the assets for a price that it feels reflects their value. Instead, the parent company sets the assets up as a separate company, then hands out shares in that publicly listed firm to its current investors.

The management of a parent company will only spin off the unwanted business if it’s fairly confident that this will pay off for shareholders in the long term, if not in the short. Generally, the parent company guesses right.

A spinoff investing strategy is especially attractive for value-seeking investors

Companies that offer spinoffs do so when they feel it isn’t a good time to sell, and that probably means it’s a good time for investors to buy. This is the reverse of what happens in new issues or IPOs.

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.

One group of investors who might be willing to buy a new spinoff right away are value-seekers. On the whole, it pays to follow the lead of these value-seekers. But you’ll need to have a bit of patience to hang on during an initial period when reluctant spinoff holders may exercise their urge to sell.

They outperform comparable stocks for years “We can say without reservation that, in investing, spinoffs are the closest thing you can find to a sure thing. It all comes down to the incentives when companies spin off a subsidiary or division and hand out shares to their shareholders. Study after study has shown that after an initial adjustment period of a few months, spinoffs tend to outperform groups of comparable stocks for several years….” Pat McKeough shows how spinoffs and other “special situations” can create windfalls for informed investors.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Spinoff investing also tends to attract big takeover offers

When an acquiring company makes a bid to assume control of a target company, it often pays a high price to buy a majority stake. Takeovers consistently offer a windfall to investors holding the shares of the target stock

Both spinoffs and parents experience an unusually high incidence of takeovers, according to Journal of Financial Economics study.

Meanwhile, we have created an exclusive proprietary rating system—our Takeover Target Rating—that will alert you to these rare but highly profitable opportunities.

To give investors advance notice of the possible takeover of a recent spinoff, or its former parent, we zero in on 13 factors that enhance its appeal to potential buyers. Here are three:

• Operates in a consolidating industry, which enhances its appeal for competitors seeking economies of scale.
• The spinoff company has good management/industry experts that the buyer can put to more profitable use.
• Profit margins are lower than industry norms. That leaves room for the buyer to cut costs and improve profits.

Here’s a classic example:

Fording Canadian Coal Trust was one of five spinoffs from the original Canadian Pacific Railway Ltd. When we recommended it in January 2008, it was trading at $47. We liked its prospects as a major metallurgical coal producer for steelmaking, and its steady cash distributions to shareholders. And we liked its appeal as a takeover candidate.

Not long after we recommended it, Teck Cominco (now Teck Resources) launched a takeover bid that pushed Fording’s shares up 162.3% in five months!

Overall, spinoff investing leads to success for investors

We’ve had great success with a number of spun-off stocks over the years. That’s especially true of the many spinoffs we have recommended that have gone up after they began trading and have later attracted a takeover bid at a substantial premium over the market price.

Many investors look to sell their shares in a spinoff company shortly after they receive them. Have you done the same only to regret it?

Have you ever received shares in a spinoff and then moved to buy more? What was the outcome?