How THIS Can Line Your Pockets
It seems almost every trader, at some point, searches for that magical, mystical, free-lunch kind of trade …
Unfortunately, just like unicorns, there’s no such thing as a free lunch. But there is a certain type of investment that historically beats the market every year.
What is it?
Stock spinoffs and variations.
When certain criteria are met, these breakaways see an average return roughly 10% higher than the rest of the market.
Now, a word of caution from your friendly penny stock day trader: Nothing is a sure thing. Recently the market is just as brutal to spinoffs as it is to other companies.
Also, this is not a fast in-and-out play. Most positive price action from spinoffs happens a few months after the subsidiary becomes its own company.
Let’s take a look at how this works so you can make an informed decision about spinoffs.
What Are Stock Spinoffs?
A spinoff is the creation of a new, independent company from a division of a parent company.
The parent company either sells or distributes shares of the new company — hence the term stock spinoff. Shareholders in the parent company are given shares in the new company on a pro rata basis.
Benefits of a Stock Spinoff
There are a few reasons why the parent company might want to form a new company, but in the end, it’s about creating more value for shareholders.
The division being spun off might be underperforming or outperforming the core business. Or the spinoff may be moving in a different direction or be a very different type of business in relation to growth and risk.
One way to analyze the benefits of a spinoff is to view it from a mergers-and-acquisitions perspective.
When companies merge, the C Suite and board of directors usually give reasons involving economies of scale and synergy. It’s believed that combining the two companies will create more value for shareholders.
While a spinoff seems to go against this, it’s not always the case. Sometimes these big conglomerates become sluggish, losing their sense of agility. Sometimes the synergy just plain doesn’t work out or economies of scale never materialize.
At that point, the merger starts to look bad for both companies… so the parent company spins off the subsidiary.
Other times, the parent company may have grown into several unrelated business divisions. Then a spinoff makes sense for both the subsidiary and the parent company.
Maybe different divisions have different growth outlooks or different levels of risk. A stock spinoff allows each company’s management to focus on its core business.
Benefits of the Stock Spinoff for the Parent Company
For the parent company, the benefits are based on either business optimization or a political agenda.
In the case of politics, a company might pursue a spinoff to avoid regulatory pressures in a specific geographical area.
And if the parent company spins off the subsidiary for business optimization, it could be for several reasons. Here are just a few:
- Shedding an underperforming part of the business.
- Releasing a strong performing division to create more value for shareholders.
- A return to the core business.
- A desire to focus on fewer geographical areas.
One interesting thing to note here:
Many spinoffs result in the subsidiary taking on corporate debt. This can improve the parent company’s fundamentals in the quarter following the stock spinoff.
It seems like burdening the subsidiary with ‘toxic debt’ would be bad for the new company — but that’s not always the case. Sometimes it can even help with initial downward pressure on the stock, giving you a better idea of when to enter your position.
Benefits of the Stock Spinoff for the Subsidiary
The spinoff can also see a number of benefits …
- The freedom to operate in line with core business strategies.
- The agility to open new markets.
- Separating from a parent company that’s not performing as well.
- Room for the new company’s management to maneuver without worrying about the parent company.
Also, if there are regulatory issues, the parent (or subsidiary) can operate free of these pressures.
Say Amazon were to spinoff its cloud-based web services division (AWS) from its e-commerce platform. Why the spinoff? One reason may be to avoid regulatory issues with the federal government.
(Note: This hasn’t happened, but it has been discussed by analysts.)
Benefits of the Stock Spinoff for the Shareholders
For shareholders, a spinoff means the stock they own becomes what’s called a pure play business. After the spinoff, they own shares in two companies — each focused on their core business in one industry or market sector.
There’s less muddying of the waters like you might see with some corporate behemoths.
When the spinoff happens, shareholders are given shares in the new company on a pro rata basis. Each company is owned by the same stockholders in the same proportion as the parent company.
Sometimes shareholders have a choice about whether they take part in the spinoff, but most of the time, they receive shares of the spinoff as a type of dividend.
There’s an interesting phenomenon that occurs when a conglomerate spins off a subsidiary.
First, there’s downward pressure on the price. That happens for a few reasons, and it’s important you understand them …
The first reason has to do with institutional investors. Many institutional investors hold a certain dollar amount of each stock in their fund.
Here’s an example: Say Fund X owns $10 million worth of 10 different companies. One of the companies, Company C, decides to spinoff a subsidiary into Company S.
When Company S is formed, Fund X now owns a stake in both Company C and Company S. But owning Company S doesn’t make sense for Fund X.
Maybe the stake is too small. Maybe the spun-off company no longer matches the industry sector of Fund X … Whatever the reason, Fund X sells its entire stake in Company S.
Let’s Look at the Second Reason for Downward Pressure:
Individual investors often sell their newly spun stock right away — just like the institutional investors. Maybe the new company doesn’t meet their investment criteria or they want to invest the proceeds back into the parent company.
It’s fairly common.
When both institutional investors and individual investors attempt to sell at the same time, supply outstrips demand. So what happens next?
If you guessed the price goes down, you’re right. All that selling creates downward price pressure that has nothing to do with the actual value of Company S stock.
So why doesn’t Company S try to promote its newly trading stock to keep the price up?
Because many of the stakeholders in Company S are waiting for their share distribution as part of the spinoff. They benefit from being offered undervalued shares.
So they keep their collective lips zipped and wait for the market to catch up with the fundamentals. And they reap a nice profit along the way.
It also gives them a huge incentive to make the spinoff profitable. When the stock goes up, their executive compensation packages get bigger.
What Is the Difference Between a Spinoff and a Split-off?
Both spinoffs and split-offs are a form of divestment or divestiture. Divestment is the opposite of investment and involves a company selling assets. When a parent company sells off a business division to create a new company, it’s a form of divestiture.
In a spinoff, every shareholder is given a share distribution in the new company — like a dividend.
On the day of the spinoff, the value of the shares they hold is the same as owning shares in the parent company before the spinoff.
Let’s Look at an Example…
Big Fast Company decides to spin off its sports car division. Shares in Big Fast Company go for $50 on the day of the spinoff. The spun-off company will be valued in such a way that its shares will be worth $10 each.
On the day of the spinoff, shareholders own two different stocks. For every share of Big Fast Company they owned before the spinoff, they now own one share of Big Fast Company and one share of Fast and Furious Super Cars.
The combined value of the two shares would still equal $50 at market open …
If Fast and Furious Super Cars opens at $10, then Big Fast Company opens at $40. This is a simplified example, but you get the idea.
There are variations on how the stock is issued. Sometimes shareholders get cash plus a percent of a share of the new stock for each parent company share they own.
If you’re going to play a stock spinoff as a trader, you want to know its exact details: What do you get in exchange for owning the parent company shares when the spinoff occurs?
It’s all part of your research and due diligence.
In a split-off, shareholders have to exchange shares of the parent company for shares of the new company.
A key difference is how the subsidiary is valued in a split-off. That’s because the subsidiary shares are offered as part of an initial public offering (IPO) through what’s known as a carve-out.
Only after the IPO, when the market determines the value of the new stock, does the stock split-off involve shareholders of the parent company.
Historically, spinoff stocks have presented great opportunities to line the pockets of those who know how to navigate their ins and outs.
In the next issue, I’ll cover how to find spinoffs that will deliver strong returns, give you some tips and tricks to use in your own trading, and avoid the risk of going too big too fast.
Remember, this type of trading strategy isn’t one size fits all, so it might not work for your specific trading style.
But the more you know the better your trading will become!
Make sure if you are planning to tackle this style of trading, that you study the companies that are spinning off.
Utilize this knowledge along with the other tools we’ve been working on to boost your trading!