A corporate spinoff occurs when a parent company breaks off part of its business into its own separate firm. The most common approach is to spin the new company off to existing shareholders who receive shares in the spinoff and maintain their interest in the parent company.

More Companies Turning to Spinoffs
A recent article in the Wall Street Journal highlighted that companies are increasingly turning to spinoffs. The U.S. economy (as well as other economies throughout the world) has been struggling to grow following the credit crisis. As a result, corporations have had to get more creative in finding ways to increase shareholder value.

Spinoffs have a solid track record of boosting returns for shareholders, which corporate management teams are increasingly well aware of. At the end of 2011, Bloomberg estimated that spinoff activity had reached its most active period in over a decade and that 145 spinoffs were announced in the first half of 2011. Many large firms, including Kraft, Abbott Labs, Sara Lee and Ralcorp Holdings, have completed or are in the process of spinning out certain operations into their own publicly-traded firms.

Reasons for a Spinoff
There are many reasons why spinoffs make sense. The primary motivation is to improve performance. By separating businesses, each new entity is freed up to focus on a more specific industry or area of the marketplace. It can also help the parent company focus its operations and spin out units that it thinks have less growth appeal or a better chance at improving growth prospects on their own. Both Kraft and Abbott Labs are spinning off more mature business units to focus on operations that offer more appealing growth prospects, such as in international markets or market segments that are simply growing faster.

Why Spinoffs Work
Past studies have demonstrated that spinoffs work. A 2004 study entitled Predictability of Long-Term Spinoff Reports, performed by two professors at Purdue University, estimated that the spinoff companies outperformed their industry benchmarks by more than 20% over the three-year period from when the spinoff first occurred. It also found that the parent company outperformed. However, the study contained one significant outperformer that greatly increased the average return over the 36-year period it studied.

Earlier studies from the 1990s also detailed spinoff outperformance, as have books that covered the subject during the same period. Joel Greenblatt's 1997 book "You Can Be a Stock Market Genius" devoted a full chapter to spinoffs and is credited with helping popularize spinoffs as a specific investment strategy. In chapter three, he cites studies that estimate 10% per-year outperformance by spinoffs, with 6% outperformance from parent companies as well.

Greenblatt makes an important point when he states that existing shareholders generally sell off the shares they receive in the new spinoff. Their original motivations remain with the parent company, meaning they are less interested in what initially looks like a company operating in a less appealing area of the market. For this reason, spinoffs can be subject to early selling pressure, which serves to increase their appeal and upside potential for investors.

f course, the newly formed company eventually needs to start competing and growing its sales and profits. The same goes for the parent company. A key recommendation of Greenblatt is to focus on spinoffs in general, but do a significant amount of research to find firms that stand out for their upside potential. In this respect, the process is no different from finding appealing stocks to invest with.

Initially, not much information is available on the new company that investors can use. It can also take time for Wall Street analysts to start coverage and they may be less interested to do so, because there is more money to be made in underwriting initial public offerings (IPOs), debt and other investment banking activities.

Spinoffs can also be tax advantageous and spun out to existing shareholders without triggering any capital gains or other taxes. Once a company is spun out, it may become the target of a rival or other strategic investor. Buyouts can occur at a significant premium to the existing share price and result in yet another way for investors to earn outsized returns.

The Bottom Line
The current market environment is turning out to be ideal for spinoff activity and offers investors a great opportunity to wade through a wide array of new companies that have a solid track record at beating the market. The prospects of the parent company can also improve, but the spinoff has selling pressure and other unique circumstances that can make them even better investment candidates.

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