When a company spinoff takes place, it’s often because its management sees it as a good time to do so. As part of that, companies will typically offer a spinoff when conditions are profitable for investors

While choosing stocks to buy we look at a variety of factors. Some aim to help us spot what we refer to as “hidden assets,” which are the kind that investors tend to overlook. (We also look out for “wariness factors” as part of our Successful Investor philosophy. Those are circumstances or conditions that can harbour little-noticed sources of risk.)

One of our favourite sources of hidden value is the company spinoff. When a company carries out a spinoff, it sets up one of its business units as a separate firm, then hands out the unit’s shares to its own shareholders as a special dividend. It’s clear that spinoffs are as close as you can get to a sure thing in the world of investing.

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.

Why we look closely at company spinoff opportunities when they come available

Study after study has shown that after an initial adjustment period—months, not years—most spinoffs start to outperform groups of comparable stocks. For that matter, the parent companies (those that set up the spinoffs) also tend to outperform comparable firms for years afterwards. Here are two reasons why.

First, a company spinoff involves a lot of work and legal fees. The parent will only spin off the unwanted subsidiary if it can’t sell its assets for what it feels they are worth. 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 often means it’s a good time to buy), or when they feel those assets will be worth much more in the future, possibly within a few years.

Second, company managers naturally prefer to add to their assets, not reduce them. Getting rid of assets lowers a company’s total potential profit. It also cuts funds available for company-manager compensation. As a rule, a company only spins off a subsidiary if it’s nearly certain that the subsidiary, and the parent, will be better off afterwards.

We’ve had great success with a number of spinoffs over the years. Many have turned into standalone successes. Others have attracted takeover bids at a big premium to the market price of their shares

Spinoffs and their parents do sometimes run into unforeseeable woes, of course. But that’s the exception.

Hidden assets can lead to a company spinoff

There are many things to look for when evaluating a stock as part of our Successful Investor philosophy. One of the most important is hidden assets, which are often the basis of a company spinoff.

For a long time we’ve written about the heads-you-win-tails-you-break-even phenomenon. That’s what you get in an investment that exposes patient investors to limited risk of long-term loss, but one that can deliver healthy if not substantial returns.

If you buy a stock for its hidden assets, but those assets stay hidden or ignored by investors— or turn out to be less valuable than you thought—it can’t hurt you much. By definition, a stock’s hidden assets have not had much impact on its price. If you paid little if anything for the assets, you have little to lose. But the best hidden assets will eventually expand a company’s profit, grab investor attention, and push up its stock price.

A company spinoff often results in an undervalued stock

When a spinoff begins trading, it stands to reason that many investors will put a low value 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 are seekers of undervalued stocks. On the whole, it pays to follow the lead of these value seekers. They have the patience to hang on through a period of sluggish trading, while reluctant spinoff holders exercise their urge to sell.

All in all, when a company spinoff takes place it probably means it’s a good time to buy.

Bonus Tip: Seek out hidden assets early

The best time to find hidden assets is when they’re still hidden, long before the company begins taking steps to profit from them. Understanding and seeking out hidden assets while you’re evaluating a stock can add enormously to your profits in the course of an investing career. It’s also a key part of our Successful Investor philosophy. But you need patience to profit from them, because they can stay hidden for a long time after you buy.

Hidden assets can also cut your risk. Stocks with hidden assets are likely to hold up better than those whose assets are easier to spot, since they are the last stocks that experienced, successful investors sell. When times are good, on the other hand, stocks with hidden assets tend to do better than average. Good times give them opportunities to put their hidden assets to work.

Are hidden assets a top priority in your stock searches, or are there other investment characteristics that you focus on?

Although spinoffs tend to be an almost sure thing, they do occasionally go awry. What experience have you had with spinoffs that failed to thrive?