There is no such thing as a risk-free investment. There is a degree of risk you assume and there are methods of negating risk. In terms of risk and return, the ultimate objective of investing is to generate the highest possible return for a given level of risk. This can be accomplished by diversifying your portfolio across asset classes, industries, and regions, and by investing in assets that have the potential to outperform the market over the long term.
One of the places I look for high returns with a lower degree of risk is in the Spinoff space (company breakup.) A company breakup, also known as a corporate breakup or corporate divestiture, is the decision by a large corporation or conglomerate to Spinoff a portion of its business units, subsidiaries, or assets. Typically, this is done to establish smaller, more focused businesses or to unlock the value of specific divisions that may not align with the core business strategy. You may have seen these companies randomly appear on your account out of nowhere. They are those additional companies you gain whether you like them or not from having an existing position in a parent company going through the Spinoff.
Historically Spinoffs are a wonderful place to find returns and recent studies suggest that they consistently outperform the market by 10% per year. They have also proved high takeover targets too. There are 8 Spinoffs coming up in October and they are big well-known names too. (DHR) announced in 2021 that it would be splitting into two companies: one for its life sciences business and one for its environmental and applied solutions business. This is happening imminently and looks value creating. Spinoffs have gained increased significance in the stock market for multiple reasons and those reasons for relevancy here boil down to a risk reward in your favor. Why more investors are not looking at them is beyond me.
Holding Spinoff companies are a terrific way to negate risk. Regular readers will know that I am always pushing managing risk ahead of reward. It is not strictly a financial term, but Spinoffs have ‘negative correlation risk.’ Let me expand a little on what I mean.
Correlation is a term used in finance to describe how closely two securities move in tandem. The range of correlation values is from -1 to 1. A negative correlation, or -1, denotes that the two securities move in perfect opposition to one another (i.e., when one climbs, the other declines). The securities move independently of one another when the correlation is zero, and they move perfectly in lockstep when it is one. Risk refers to an investment choice. The word ‘risk’ is typically used to describe the degree of uncertainty and/or potential monetary loss involved. If we mesh these terms, it implies the risk or challenges associated with assets that are negatively correlated. Having assets that are negatively correlated can be a way of diversifying a portfolio. When one asset is down, the other might be up, potentially reducing the portfolio's overall volatility and risk. But how is this achieved with Spinoffs?
Three reasons why this occurs, and they are unique to Spinoffs.
1) Diversified Business Interests
2) The Phenomenon of Market Neglect
3) The Journey of Market Value Realization.
Diversified Business Interests
(GE) General Electric: GE was once a diversified conglomerate with businesses in a wide range of industries, including aviation, healthcare, energy, and finance. However, in recent years, GE has been divesting many of these businesses to focus on its core healthcare and energy businesses. (MMM) is another diversified company with businesses in a wide range of industries, including industrial products, consumer products, and healthcare. 3M's diversification has helped it to weather economic downturns and remain profitable. Two Spinoffs that are coming up and should be watched closely.
- Less Volatility in the Portfolio: When a firm spins off a business, it forms two different companies. As a result, there is less risk across the board because the performance of one company will not have an adverse effect on another.
- Enhanced Valuation: The market frequently undervalues newly spun-off companies. This implies that once the market recognizes the true value of the business, investors can purchase shares of the spun-off company at a discount and sell them later at a profit.
- Increased Liquidity: Dividing a company into separate entities might make it simpler for investors to buy and sell its stock. This is due to the stock's increased liquidity because of being listed on a stock market.
Overall, the risk reduction benefits of spinning off diverse assets can be significant. Reducing the volatility of portfolios and improving valuation, you will potentially increase your return and reduce risk.
The Phenomenon of Market Neglect
The phenomenon of market neglect in the context of Spinoff companies refers to the tendency for these newly independent entities to be overlooked or undervalued by the broader market initially. There are several reasons for this.
- Large institutional investors, such as mutual funds, may sell shares of Spinoff companies if they do not align with their mandate or if their market capitalization is insufficient. These are examples of institutional restraints.
- Lack of Initial Coverage: Initial analyst coverage for Spinoff companies is sometimes insufficient. Many investors remain unaware or unsure of the company's potential due to a lack of Wall Street analysis and recommendations, which results in neglect.
- Information Asymmetry: The broader market might not be immediately aware of a Spinoff's full potential. External investors might not have all the knowledge or the experience to examine the Spinoff, whereas the parent firm typically recognizes its full worth and potential.
- Initial Price Pressures: The shares of the Spinoff firm may experience downward price pressure because of the institutional investors' selling. This can make the Spinoff seem like a less appealing investment to other investors.
- Management Transition: Spinoffs could include new management groups or approaches that are unproven in the market. Market participants can choose to take a "wait and see" stance until the new management demonstrates its prowess.
The market starts to see the Spinoff company's potential over time as it begins to reveal its financial results, clarifies its growth strategy, and draws more analyst attention, which results in a change in the company's valuation. For those that recognize and believe in the potential of the Spinoff early on, this shift from initial disregard to eventual acknowledgment can create investment opportunities. The interesting point about Spins is that there is not set price to their listing as opposed to IPOs. (PHIN) spun off from (BWA) in July is a great one that I believe will gain more momentum going forward.
The Journey of Market Value Realization
Spinoffs are brand-new listed companies without the fanfare. Recognizing the true value of Spinoffs is about understanding the above triggers and being patient. Over time, as the Spinoff solidifies its independent presence in the market and demonstrates its value proposition, the broader market tends to adjust its valuation perceptions. Several factors and events can trigger the market to reevaluate and appreciate the inherent worth of a Spinoff and they are key to watch out for. (CXT) NXT, Co. has been a notable example this year.
- Earnings Reports: Investors and analysts can feel more confidence about the company's prognosis as Spinoff firms begin to produce their own quarterly and annual financial statements that show profitability or growth potential.
- Analyst Coverage: A rise in financial analysts' coverage of a Spinoff might boost its visibility. Increased investor interest and trust can result from strong recommendations or in-depth analyses.
- Management Exhibits: A Spinoff's management team may embrace new tactics, penetrate new markets, or streamline operations. The market may start to have more faith in the management's ability as these efforts begin to pay off.
- Debt Structuring and Management: Good debt management, refinancing, or obtaining advantageous loan terms can have a positive impact on the Spinoff's financial health and the outlook for the market.
- New Contracts or Partnerships: The announcement of significant agreements, joint ventures, or client additions can validate the products or services of the Spinoff, indicating a strong market position or expansion prospects.
- Mergers and Acquisitions: Attention may be drawn if the Spinoff becomes an acquirer or is a target for an acquisition. If the latter, the acquisition price can frequently show how undervalued the Spinoff is.
- A Spinoff's announcement of dividends may be interpreted as an indication of sound finances and confidence in future profitability, luring income-seeking investors.
- Industry Trends: The Spinoff may profit from the industry spotlight if the industry in which it works begins to develop traction or comes to the notice of the market.
- External Validation: The reputation of the Spinoff can be improved by endorsements, accolades, or recognitions from reputable organizations or the industry.
- Interest from Individual or Retail Investors: At times, an increase in interest from individual or retail investors, sparked by social media or investing platforms, can draw attention to the Spinoff and boost demand for its shares.
Shares are gradually distributed as institutional investors who may have initially sold the Spinoff shares (because to policy restrictions or other reasons) withdraw from the market. More price stability and more sorts of investors may be attracted because of this dispersion.
Spinoffs frequently have different dynamics, financial structures, and market expectations. These newly independent businesses may encounter difficulties building their brands, streamlining processes, or navigating complex financial situations without the protection of the parent company. Investors should therefore carefully evaluate the management team, the Spinoff's growth strategy, its financial situation, and the competitive environment. Understanding the causes behind the Spinoff might also help you better grasp the potential benefits and dangers.
Spinoffs can be a gold mine for individuals who want to maximize their returns and negate risk at the same time. You should be looking at the ones coming up.
On the date of publication, Jim Osman had a position in: MMM , DHR , PHIN . All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
