A spinoff investment will likely be undervalued and it’s almost always a better option than new issues or IPOs

A spinoff investment is created when a company sets up one of its subsidiaries or divisions as a separate company, then hands out shares in the new company to its own shareholders. It usually hands out the shares as a special dividend, but from time to time it gives its shareholders an opportunity to swap shares of the parent company for the shares of the newly established spinoff.

Study after study has shown that following an initial adjustment period of a few months, stock spinoffs tend to outperform groups of comparable stocks for several years; the parent companies also tend to outperform comparable firms for several years after a spinoff.

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Why a spinoff investment is a good decision

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 generally only spin off the unwanted subsidiary if it can’t sell the stock for what it feels it’s worth.

As a general rule, you’re better off buying more of any stock you receive as a spinoff, rather than selling.

A spinoff investment is likely an undervalued stock in disguise

Companies often do spinoffs when they feel it isn’t a good time to sell. Instead, they choose to hand out shares of the new firm to their shareholders. That often results in buying opportunities in undervalued stocks.

When a spinoff investment 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. Moreover, there is often little, if any, brokerage research available on the new company.

One group of investors who might be willing to buy a new spinoff are those 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 seekers of undervalued stocks, and to hang on through a period of sluggish trading while reluctant spinoff holders exercise their urge to sell.

A spinoff investment is a better option than a new issue

There’s an element of chance in the success or failure of every business, especially when it’s just starting out. This fact has a continuing impact on our approach to investing.

One key reason why we generally stay out of new issues is that they tend to be riskier than investors realize. New issues tend to be risky due to what you might call “the selection process.” You can only invest in new issues that come to market.

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.

Speaking very generally, your best course of action as an investor is to stay out of most new issues. You’re better off to wait until they have been trading for a few years and have shown some of the potential that the initial hype promised. Even with seemingly attractive new issues, it’s best to stay out. If a new issue has genuine long-term investment appeal, it will be an attractive buy for months or years after it reaches the market.

A lot of investors don’t like spinoffs, but they can be a great buy for patient investors. What’s the longest you’ve held a  spinoff before it started performing well?