5 tips from our TSI Takeover Target Rating system for even better results with spinoff investing

We can say without reservation that spinoff investing is the closest thing you can find to a sure thing. It all comes down to the incentives.

Companies do spinoffs when they feel it isn’t a good time to sell, often resulting in undervalued stocks. That probably means it’s a good time to buy.

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We like spinoff investing because of the performance

When it comes to a corporate spinoff, 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. That above-average performance makes sense for a couple of reasons.

First, corporate 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. That’s why companies only have an incentive to do spinoffs under two sets of favourable conditions: When they feel it isn’t a good time to sell (which, as mentioned, often means it’s a good time for investors to buy); or when they feel the assets they plan to spinoff will be worth substantially more in the future, possibly within a few years.

Second, company managers naturally prefer to acquire or expand their assets, not get rid of them. Getting rid of assets reduces a company’s total potential profit, which reduces the funds it has available to pay its managers. The management of a parent company will only hand out a subsidiary to its own investors if it’s fairly confident that the subsidiary, and the parent, will be better off after the spin off than before.

We like spinoff investing, but not everyone sees the value

Oddly enough, many investors react to spinoffs as a nuisance, because they leave you with a tiny holding in a stock you didn’t choose and know little about. As a result, these investors may dump any spinoffs they receive as soon as they get around to it. They’d be better off to buy more of any spinoff they receive, because spinoffs seem to come with the odds set in the investors favour.

Needless to say, things don’t work out this well every time. Corporate spinoffs and their parents sometimes run into unforeseeable woes. Overall, we think it’s a good bet that both the parent and spinoff will prosper.

One group of investors who might be more than willing to buy a new spinoff are seekers of undervalued stocks who have taken the trouble to read the voluminous material that companies hand out as part of the spinoff process. But on the whole, it pays to follow the lead of these value seekers. You should have the patience to hang on through a period of sluggish trading, while reluctant spinoff holders exercise their urge to sell.

How to profit with spinoff investing

Our TSI Takeover Target Rating considers a range of factors to determine the chances of a spinoff company attracting takeover interest:

Here’s a look at some of the key factors that enhance a spinoff’s takeover appeal. We use these factors to calculate our TSI Takeover Target Rating:

• General profitability, with low debt.
• Hidden assets such as a strong customer base, real estate, or well-known brand names.
• The absence of a major shareholder and little regulatory or anti-trust contraints.
• A total market value that makes the spin off a manageable purchase for a major competitor.
• Top-quality, but underperforming, assets. Prospective buyers within an industry look at a spin off company’s poor management or the lack of financial resources limiting its growth as an opportunity for a big profit boost.

We’ve had great success with spinoff investing 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.

Can you think of investing strategies that rival spinoff investing? If so, what?  

What is your experience with spinoff investing? Have you ever sold a spinoff only to watch its price skyrocket?