Companies use mergers, acquisitions and spinoffs to increase their profits. Strategic mergers and acquisitions (M&As) can help a company become more competitive in its field and improve its bottom line, while spinoffs are a way to get rid of underperforming or non-core business divisions that can drag down profits. While mergers, acquisitions and spinoffs can be great moves for companies, they can be even better for the enterprising investor willing to do a little research. If you do your homework, you can find profitable opportunities in these corporate actions. We'll take you through this process step by step.
Why are spinoffs such a great investment opportunity? Typically, underperforming business divisions are loaded with debt. When they are cut off from the parent company, that company can become more valuable as a result.
Here's how a typical spinoff situation works:
- The company decides to spin off a business division.
- The parent company files the necessary paperwork with the Securities and Exchange Commission.
- The spinoff becomes a company of its own and must also file paperwork with the SEC.
- Shares in the new company are distributed to parent company shareholders.
- The spinoff company goes public.
Notice that the spinoff shares are distributed to parent company shareholders. There are two reasons why this creates value:
- Parent company shareholders rarely want anything to do with the new spinoff. After all, it's an underperforming division that was cut off to improve the bottom line. As a result, many new shareholders sell immediately after the new company goes public.
- Large institutional investors are often forbidden to hold shares in spinoffs due to the smaller market capitalization, increased risk or poor financials of the new company. Therefore, many large institutions automatically sell their shares immediately after the new company goes public.
Simple supply and demand logic will tell you that such a large number of shares on the market will naturally decrease the price, even if it is not fundamentally justified. It is this temporary mispricing that gives the enterprising investor an opportunity for profit.
Information is easy to find when it comes to spinoffs. Every parent company is required to file paperwork with the SEC outlining everything that an investor needs to know (and then some). The most important form to look for is Form 10, which outlines the spinoff distribution terms. This document contains a few key things to look for:
- Basic Company, Share and Pricing Information: Look at the new company's market cap. If it's smaller, large funds are more likely to sell it. Also look at the share distribution terms to see whether it makes sense to buy the parent company shares or to buy on the open market after the company goes public.
- Distribution Type: Often, spinoff shares are distributed to parent company stockholders; however, in some cases partial spinoffs, rights offerings or other formats are used. This can provide increased leverage or other advantages.
- Insider Distributions: Insider holdings and activity are key when determining the value of a spinoff. High insider ownership gives management incentive to perform well and drives shareholder value.
It is also a good idea to read press releases, related news coverage and other available media to determine how the public will react to the new spinoff. Press releases can be found under the company's ticker on Yahoo Finance, and company news can be found on Google News.
Overall, spinoffs outperform the market because of the inherent flaws in the spinoff process. Although not every spinoff opportunity represents an attractive investment, investors willing to dig a little deeper into SEC filings and press releases can find those that are with relative ease.
Mergers and Acquisitions
Companies are notorious for failing at mergers and acquisitions—especially the mergers where two extremely large companies join forces. Add to that the fact that the M&A field is heavily dominated by arbitrage funds and other big players, and you may wonder how any small investor can make a profit. In fact, M&As can provide good opportunities for investors—it's just a matter of knowing how to find them.
While most M&A transactions are handled through stock and cash offerings, others are handled through the use of merger securities. These can include bonds, warrants, preferred stock, rights and many others. Here's how the process works:
- The acquiring company decides that it wants to buy or merge with another company.
- It announces this intention either privately or publicly in a statement, hostile acquisition of stock, rumor, offering or other means.
- The company being acquired then considers the bid. The board of directors advises shareholders of the company's recommended vote and then sends out a proxy to all shareholders, who vote on whether to sell the company.
- If the merger is approved, both companies file the necessary paperwork with the SEC outlining the terms, time and other details of the sale.
- The company is bought and integrated into the acquiring company, and the acquired company's shareholders are compensated.
As mentioned above, these M&A transactions take place with cash, stock or other instruments. Cash transactions provide limited opportunity for retail investors, because any value has already been taken away from arbitrageurs well before the transaction takes place. The same is often true with M&As that take place with stock offerings, because these provide the opportunity to short or buy the acquiring company's stock.
Merger securities are another story. Often, nobody wants to deal with merger securities for the same reasons they don't want to deal with spinoffs—because they aren't allowed to (as is the case for larger funds) or because they don't care for or understand the new securities. This presents another great opportunity for investors to profit.
The most important SEC filings to look at when researching merger securities are:
M&A deals vary greatly in what's offered; therefore, it is important to carefully analyze each deal. Mathematics can tell you the fair value of the securities being offered, and a look at management can show how serious the company is about maintaining performance.
Overall, M&A deals involving merger securities, rather than cash or stock, present a great investment opportunity for the same reason as spinoffs—they are ignored by most of the public. However, like spinoffs, it is important to carefully research each opportunity before buying.
- EDGAR Database: This is the SEC's database where investors can find all company filings free of charge.
- SECFilings.com: This is a free website that lets you sign up for email alerts whenever certain types of filings are made—an excellent way to have investment opportunities delivered to your inbox every day.
The Bottom Line
Both spinoffs and M&A activity present great investment opportunities for investors willing to dig in to the SEC filings and press releases to find the information they need. In the best of situations, spinoffs continue to outperform the market, while mergers involving obscure offerings continue to cause unjustified selling.