New stock issues can be in the form of a spinoff or an IPO. One option is a much better investment than the other

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.

A company’s move to issue a new stock as a spinoff can involve incentives that work in your favour. This is easier to understand if you contrast spinoffs to one of the least-desirable investments, new stock issues, or IPOs, where the incentives work against you.

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The popularity of IPOs can lead to bad investing decisions

Some new stock issues—so-called “hot new issues”—begin moving up as soon as they hit the market. Some hot new issues even “gap upward” on their first day of trading; that is, their first public trading takes place well above the new issue price. This possibility attracts buyers who fail to appreciate how rare it is, not to mention how unlikely it is, that they will get to buy a hot new issue at the new issue price.

After all, the underwriting brokers can generally tell when a new issue is going to be “hot,” based on the reaction of their biggest clients (who of course get first pick on all new issues), and the media. Brokers reserve most of their allotments of hot new issues for their biggest and best clients. New clients and occasional new-issue buyers may get to buy token amounts of a hot new IPO, if any.

Your best course as an investor is to stay out of most new issues, even those that seem to have serious appeal. It’s usually better to hold off on buying until a new issue has been trading for a few months if not years, and has shown some of the potential that the initial hype promised.

Why spinoffs are better to invest in than IPOs

When a company carries out a spinoff, it 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 may hand out the shares as a special dividend, or give 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 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.)

New stock issues: Spinoffs make more sense than IPOs for a few reasons

First, an IPO is the initial sale of stock by a company as it goes public. Initial public offerings often have a turbulent start on the stock market. Shareholders often sell a portion of their shares to recoup their investment during the first weeks and months that the stock begins trading. We generally advise investors to stay out of IPOs.

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. This cuts into the funds available to pay managers, and reduces their opportunities for career advancement. The management of a parent company will only hand out a subsidiary to its own investors if it’s nearly certain that the subsidiary, and the parent, will be better off after the spinoff than before.

Third, spinoffs involve a lot of work and legal fees than IPOs. 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 often means it’s a good time to buy); or, when they feel the assets they plan to spin off will be worth substantially more in the future, possibly within a few years.

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.

Spinoffs and their parents do sometimes run into unforeseeable woes. But on the whole, in investing, spinoffs are the closest thing you can find to a sure thing.

Have you lost money on IPO new issues? What do you think you would do differently if you had the same opportunity to buy them again?