Why You Shouldn’t Sell Spin-off Stocks

Ever see a strange, odd-lot position appear in your brokerage account … and not have a clue where it came from?

For example: 10 shares of Adient (ADNT), 20 shares of Quality Care Properties (QCP), 4 shares of AdvanSix (ASIX), 50 shares of Versum Materials (VSM), 50 shares of Fortive Properties (FTV), 16 shares of Ingevity (NGVT).

It doesn’t even have to be an odd-lot, or an unfamiliar name. You might even have seen an even 100 shares of PayPal (PYPL) land in your account.

If this type of scenario sounds familiar, you’ve most likely received "spin-off" shares.

A spin-off is when a parent firm distributes shares of a spun-off subsidiary to parent shareholders.

The case for keeping a ‘child’ stock: Spin-offs returned +714%, while the S&P 500 Index returned +155%, over the past 14 years.

The above seven companies were spun off from more-recognized parent companies — Johnson Controls (JCI), HCP Inc. (HCP), Honeywell (HON), Air Products & Chemicals (APD), Danaher (DHR), WestRock (WRK) and eBay (EBAY), respectively. And those mostly "odd" share lots were based on owning 100 shares of these "parent" stocks.

From an investing standpoint, most investors — amateur and professional alike — sell these shares after noticing the new position.

It’s understandable why spin-off shares are liquidated in knee-jerk fashion …

  For everyday investors, they may not have the time or desire to research a new company … the "stub," or "child," shares aren’t worth keeping (or putting more cash into) … or they just want to declutter their portfolio.

  As for institutional investors, the new company may not meet certain portfolio requirements. The new company has too small of a market cap … a similar company is already represented in the portfolio … or a strategy could be constrained by indexing requirements.

These mass sell-offs often create a vacuum of downward pressure on the share price soon after a spin-off takes place.

But, investors who blow out spin-off shares soon after receipt are often making a costly mistake.

You see, the price decline is typically temporary. That’s because it’s not attributable to a company’s business fundamentals.

Don’t Sell Those Spin-offs:
They Tend to Outperform!

Many academic studies have confirmed that spin-offs outperform the overall market by a large margin …

  In a study of 168 large ownership restructurings from 1988 to1998, spin-offs substantially outperformed the market. They showed a two-year annualized return of 27%, compared with 14% for the Russell 2000 and 17% for the S&P 500. — The McKinsey Quarterly

  Between 1965 and 1994, a sample of 174 spin-offs returned an average of 18% in the first year, 51% in the first two years and 76% in the first three years outpacing the S&P 500 by 31%. — Professors James Miles and Randall Woolridge of the Penn State Smeal School of Business

  From 1985 to 1995, research on 77 spin-offs showed that during the first 18 months of trading, the average spin-off beat the stock market by more than 20%. — JPMorgan

These studies are somewhat dated. But more recent data shows that the same story still holds true …

Spin-offs, as a group, outperform the broader stock market.

Over the last 14 years (from Dec. 31, 2002, to Dec. 30, 2016), the Bloomberg U.S. Spun-Off Companies Index returned +714%, while the S&P 500 Index returned +155%.

And check out the consistency of calendar-year outperformance over the last decade:

Source: Morningstar

The S&P U.S. Spin-Off Index easily outran the S&P 500 Index in eight of the last 10 calendar years. (Including almost doubling up the index in 2016.)

Why Do Spin-offs Prosper?

I reached out to the foremost expert on spin-offs the other day …

Joe Cornell is the founder, president and controlling principal of Spin-Off Advisors LLC. He’s published "Spin-Off Research," an advisory service that features information, commentary and buy recommendations on spin-offs, for 20 years.

It’s probably safe to say this guy has forgotten more about spin-offs than anyone else knows.

(Institutions and financial advisers can learn more about Joe’s services, right here. Annual subscriptions to his publication cost $26,000.)

Joe, who prides himself on his "sum of the parts is greater than the whole" mentality, told me:

"Spin-offs often result in a higher aggregate value for the constituent pieces.

"Many diversified companies are electing to spin off parts of their business, finding that this restructuring technique can create significant value for shareholders. There were 35 spin-offs in 2016 (worth about $100 billion in initial market value).

"Why do spin-offs prosper?

"Much of the impressive performance comes from the altered dynamics of the spun-off business and its parent. Spins do well partly because when a business and its management are freed from a large corporate entity, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course. Managers have greater freedom to pursue new ventures, streamline production, and pare overhead. After the spin-off, stock options can also more directly compensate management of the new company.

"This often leads to improved operating performance over time. When one reconstitutes the parent and spin-off after a one to- two-year period, often outstanding overall returns are observed."

So, how can you take advantage of the spin-off phenomenon? Other than leaving your next spin-off position alone, there’s another simple, one-click way …

The ‘Spin-off ETF’

The Guggenheim S&P Spin-Off ETF (CSD) launched on Dec. 15, 2006.

This ETF has beaten the S&P 500 over the previous one, five and 10 years.

CSD ran up 85% over the past five years, while the S&P 500 gained 78%.

A recent index switch on May 20, 2016 — from the Beacon Spin-Off Index to the S&P U.S. Spin-Off Index — may aid return improvement going forward.

CSD’s new index, which has outperformed its old index over time, measures the performance of domestic companies that have been spun off from larger corporations within the past four years.

It includes companies derived from different types of spin-offs:

  Traditional spin-offs: Parent firm distributes shares of a spun-off subsidiary to parent shareholders.

  Carve-outs: Parent firm sells a percentage of the subsidiary to public shareholders.

  Split-offs: Parent company offers shares of the subsidiary in exchange for the parent company’s shares.

According to CSD’s prospectus, the S&P U.S. Spin-Off Index’s construction works like this:

1. The Index is comprised of equity securities added to the S&P United States Broad Market Index that have been spun-off and have a float-adjusted market capitalization of at least $1 billion.

2. The Index is weighted by float-adjusted market capitalization, subject to a maximum weight of 7.5% for any single stock.

3. Additions to the Index are made at each monthly rebalancing after the close of trading on the third Friday of each month. Any eligible spin-off occurring at least seven business days prior to the rebalancing date is included in the Index at the monthly rebalancing.

4. A constituent security that has been included in the Index for more than 48 months is removed at the subsequent monthly rebalancing; however, if the deletion of a constituent security would result in the number of constituent securities of the Index being less than 20, the deletion will be delayed until the next monthly rebalancing where the resulting number of constituent securities would be at least 20.

This methodology results in 64 current holdings. Here’s a sampling of top companies that pass the test:

Source: Guggenheim Investments, CSD Holdings 1/4/17

You’ll see that Fortive (FTV) — the Danaher spin-off we mentioned earlier — is CSD’s sixth-biggest holding, at 5.3%.

And since FTV began trading on the New York Stock Exchange last summer, the stock has gained 25%!

In the end, you can profit by investing in the stocks that most investors don’t want. Spin-off investing has proven to be a time-tested, unconventional strategy that beats the market.

To learn more about the Guggenheim S&P Spin-Off ETF (CSD), click here.

Best,
Grant Wasylik

Originally from Pennsylvania, Grant graduated from Juniata College with an economics major and accounting minor. Since graduation, Grant has worked in the investment industry for almost two decades by serving in various roles … Prior to coming to…