Investing in spinoffs can boost your long-term portfolio returns

When a spinoff begins trading, it stands to reason that investors might well 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.

However, one group of investors who might be interested in investing in spinoffs are seekers of undervalued stocks—and on the whole, it pays to follow the lead of these value seekers. You should also have the patience to hang on through perhaps a period of sluggish trading, while the reluctant spinoff holders mentioned above exercise their urge to sell.

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Investing in spinoffs can lead you to some of the biggest undervalued stocks in the market

We can still say without reservation that, in investing, stock spinoffs are the closest thing you can find to a sure thing.

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

Quite often, a big company will spin off a small subsidiary because it feels the subsidiary is a tiny gem but is too small to make an impact on the parent’s much larger financial statements and market capitalization.

4 major benefits of investing in spinoffs

• Spinoffs offer flexibility. Spinning off unwanted assets lets parent-company managers focus on the part of their business they want to retain. Usually they hold on to the part best suited to their talents.
• Spun off shares often slump when they begin trading. Many investors routinely dump stock they receive in a spinoff. They may only get a handful of shares — perhaps one for each 10 shares they own. They may have little familiarity with the shares, and coverage by brokerage analysts and the press is often minimal at first. But after this initial slump, these spun-off bargain stocks generally go on to outperform the market as a whole.
• Spinoffs are born with the proverbial “silver spoon.” Parent companies may devote great effort to ensuring they have adequate finances and strong management. They want the spinoff to succeed, for their own prestige, and because they want spun-off bargain stocks to benefit their shareholders.
• Spinoffs may facilitate takeovers.

Overall, investing in spinoffs often 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.

Bonus Tip: Find undervalued stocks using your brain and not your emotions

Market pessimism can let you find some undervalued gems—stocks that drop along with the market as a whole yet still have sound fundamentals. But one of the sweetest and most profitable pleasures of successful investing is to buy high-quality “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to their sales, earnings or assets), then hold on to them as investors recognize the value and push up the share price.

Value stocks are typically stocks trading lower than their financial fundamentals suggest. They are perceived as undervalued, and have the potential to rise. Many new tech stocks, for instance, start out as growth stocks and transition into value stocks.

When they look for value stocks to buy, investors usually start by looking at a few basic ratios. For example:

• Low price-to-earnings and price-to-book ratios—signs of possibly cheap or undervalued investments.
• Low price-to-book-value ratio—another sign that a stock may be cheap in relation to other stocks on the market.
• High dividend yield—the stock’s annual dividend divided by the share price. A high dividend yield could indicate a cheap stock that is set to rise.

Spinoffs can be misleading as they may slump as they begin trading. What qualities of spinoffs do you consider before holding them?