Money Magazine ran a great article about spin-offs in March 1999. Despite being over 10 years old, the fundamental principle that spinoffs generally outperform the market in the first 18 months of trading still holds true. Unloved and under-followed, spinoffs are often undervalued by the parent, leading to some excellent arbitrage situations. There are so many at any given time that it's led to the creation of the Claymore/Beacon Spin-Off ETF, a basket of 40 stocks tracking the Beacon Spin-Off Index. The fund's had a spotty record since its inception in 2006. Nonetheless, I'll look at three large-cap companies where owning the spinoff rather than the parent would have been the better move.

IN PICTURES: 6 Millionaire Traits That You Can Adopt

Pepsi's Profitable Spinoff
In September 1997, Pepsico (NYSE:PEP) spun-off its Pizza Hut, KFC and Taco Bell restaurants into a separate company. Existing shareholders received one share in the new company, Tricon Global Restaurants (changed to YUM Brands (NYSE:YUM) in 2002), for every 10 shares of Pepsi. Pepsi's CEO at the time, Roger Enrico, believed this separation would allow it to focus on its packaged goods business, which is a very common reason for making the move. However, it didn't help Pepsi shareholders much. Many Pepsi shareholders likely sold the new stock as soon as it hit their accounts. This would turn out to be a huge mistake. Since September 17, 1997, YUM Brands stock is up 520.8% compared to 132% for Pepsi and 14.4% for the S&P 500. Pepsi shareholders who kept the new stock, sold their Pepsi stock and bought more Yum stock with the proceeds would be very happy today.

Chipotle's Hot Performance
McDonald's (NYSE:MCD) first invested in Chipotle Mexican Grill (NYSE:CMG) in 1998 when there were just 16 stores, all in Denver. Today, it has over 1,000 fast-casual restaurants. In 2006, as part of a turnaround strategy, McDonald's decided to return capital to its investors through an exchange of stock. McDonald's investors could exchange one share of its stock for 0.8879 shares in Chipotle Class B stock, which was converted into common stock on a one-for-one basis in December 2009. At the time of the share exchange offer, the 10% discount to Chipotle's book value probably looked like a sweet deal. In hindsight, it was a great deal. Over the past four years, the spinoff outperformed the parent by 56.7%. Once again, rolling your McDonald's stock into Chipotle stock would have made you wealthier. (For more on playing spinoffs, read Cashing In On Corporate Restructuring.)

Mead's Healthy Gains
This last example demonstrates why the 18-month statistic mentioned in the opening paragraph isn't an aberration. In February 2009, Bristol-Myers Squibb (NYSE:BMY) sold off 15% of its Mead Johnson Nutrition (NYSE:MJN) baby formula business at $24 a share. On Mead Johnson's first day of trading, it gained 10.1%. Eighteen months later, the company's tacked on an additional 99%. Meanwhile, Mead's parent's stock has returned 26.1% over this same period. It's a respectable return, but less than the S&P 500 and clearly much less than Mead Johnson.

Bottom Line
I'm not suggesting for a moment that every spinoff performs this well. However, if you own a stock that's contemplating a spinoff, do yourself a favor and at least consider the possibility that owning stock in the new entity rather than the parent is a potentially lucrative proposition. (For related reading, take a look at Parents And Spinoffs: When To Buy And When To Sell.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  2. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  3. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  4. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  5. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  6. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  7. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  8. Stock Analysis

    Top 3 Stocks for the Coming Holiday Season

    If you want to buck the bear market trend by going long on consumer stocks, these three might be your best bets.
  9. Investing News

    Could a Rate Hike Send Stocks Higher?

    A rate hike would certainly alter the investment scene, but would it be for the better or worse?
  10. Investing News

    Corporate Bonds or Stocks: Which is Better Now?

    With market volatility high, you may think it is time to run for corporate bonds instead of stocks. Before you do take a deeper look into which is better.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!