The Hedge Fund Secret That Could Double Your Investment

posted on 06-07-2019

During my days as a financial advisor years ago, I once visited a client with a real conundrum.

She was working to get her financial affairs in order after a divorce. The good news was that while combing through some file folders, she came across a stack of old stock certificates that apparently gave her a large stake in Allstate (NYSE: ALL) and Dean Witter, Discover & Company.

The bad news? She couldn't remember buying them and wasn't sure where they came from.

After doing a little homework, I figured out that the mystery shares had been sent by Sears (Nasdaq: SHLD) -- and my client was a longtime Sears shareholder.

You see, Sears acquired brokerage firm Dean Witter in 1981 and introduced the Discover (NYSE: DFS) credit card to shoppers just a few years later. Then, in 1993, Sears raised $900 million by selling 20% of its ownership in Dean Witter, Discover & Co., and the other 80% was allocated to Sears shareholders through a spinoff. Soon after, Sears did the exact same thing with Allstate.

So instead of one stock, my client now owned three. And unlike many investors, she hung on to them.

Head Spinning Profits
Quick question: What do Lucent Technologies (NYSE: LU), American Express (NYSE: AXP) and Yum Brands (NYSE: YUM) all have in common?

On the surface, not too much. But at one point in their history, each of these firms was spun-off from a larger parent company.  

And eagle-eyed investors are always on the lookout for these deals because corporate spinoffs have proven to be fertile ground. In fact, some pros devote their careers exclusively to these transactions and nothing else.

It's easy to see why. In 1999, consulting firm McKinsey conducted a comprehensive study of 168 restructurings during the prior 10 year period. They found that shares of spinoffs produced annualized gains of +27% in the 24 months following separation, versus +17% for the S&P 500.

That performance could have turned a $10,000 investment into more than $109,000 over 10 years versus just $48,000 in an index fund. And that figure is for the group as a whole -- no effort was made to identify the best-positioned spinoffs with the most potential. Someone adept at picking out the strongest spinoffs could have done ever better.

In addition to the McKinsey study, several others have reached the same conclusion on the profit potential of spinoffs. Lehman Brothers found that spinoffs have an edge of more than +13%. In fact, between 2003 and 2006, two-thirds of all spinoffs outperformed the market.

Renowned money manager Joel Greenblatt wrote the book on spinoffs -- literally. His best-seller, You Can be a Stock Market Genius is one of the definitive works on the subject. Greenblatt, a former hedge fund manager and Warren Buffett devotee, has racked up annualized returns of +40% during the past two decades by identifying undervalued opportunities, including spinoffs.

Why Do Companies Spin?
Spinoffs occur when a large parent company decides to cut loose a subsidiary or division and refocus on its core operations.

These deals are done for a number of reasons. In some cases, the intent might be to offload debt or sever ties with an unprofitable unit that isn't carrying its weight. You'd probably want to steer clear of these.

But sometimes a company is forced to spin off a unit to satisfy anti-trust requirements. And other times the parent may need to resolve friction and conflicts of interest between a subsidiary and parent.

But perhaps the most promising situations arise when a fast-growing business is being held back and simply needs to be set free.

For example, armored car transport provider Brinks (NYSE: BCO) decided to carve out its home security division. So in 2008, the assets were folded into a new, standalone business called Brink's Home Security Holdings (NYSE: CFL) and given to current stockholders on a 1-1 basis -- anyone holding 10 shares of BCO was handed 10 shares of CFL.

Management could have just sold the company, but then those proceeds would have been taxable. Spinoffs are typically considered a tax-free distribution of shares, making them incredibly tax-efficient for shareholders.

True to form, shares of the new company (now called Broadview Security) have already doubled, climbing from $20 shortly after the spinoff to about $42 today.

When 1 + 1 = 3
A spinoff can be a perfect example of the sum of the parts being worth more than the whole.

Picture a large conglomerate with a dozen different segments and $5 billion in annual earnings. Under that wide umbrella, there might be a small, booming business with profits of maybe $10 million. But no matter how bright its prospects, the smaller subsidiary will always get lost in the shadow of the parent.

Even a +100% surge in earnings would only move the parent's needle 0.2%. So Wall Street can't pin an accurate price tag on the business because investors are far more concerned with what the other $4.99 billion is doing.

But as a standalone pure-play, the company might finally get the respect it deserves.

Pent-Up Entrepreneurial Forces
Companies that are spun-off also tend to be overachievers -- if for no other reason, the new firm's leaders are now free from corporate bureaucracy and sitting on a bundle in stock option incentives.

Greenblatt refers to this magical time as the unleashing of "pent-up entrepreneurial forces." But here's the real beauty: most investors don't flock to spinoffs. In fact, they do just the opposite and unload the new shares the first chance they get.

But why would they do that?

Smaller investors sometimes see the distribution as something akin to a dividend, so they sell the new shares to raise cash and reinvest back in the parent company. Institutional holders aren't any better. Their primary interest is the parent company, not a small (and generally unknown) side venture.

Against this indiscriminate selling, spinoffs often struggle in their first year for reasons that may have nothing to do with the underlying company. For the investor who's done the homework, this is a perfect time to hold or even accumulate shares, because sooner or later the new company will get to tell its story. And if that story is a good one, Wall Street will eventually respond.

Of course, the homework is the most important part. After all, some companies get discarded because they weren't worth keeping. But many go on to do great things once they're pushed out of the nest.