Managing Risk in Exports and Imports

The Key Wealth Institute is a team of highly experienced professionals from across wealth management, dedicated to delivering commentary and financial advice. From strategies to manage your wealth to the latest political and industry news, the Key Wealth Institute provides proactive insights to help grow your wealth. When a company spins off a business that may no longer make sense for it to own, the resulting entity can create an opportunity for investors. What is a Spin-Off? A spin-off refers to a corporate event in which a company creates a separate independent company from its existing business and subsequently distributes the shares of the new company to existing shareholders. Once the spin-off occurs, shareholders are free to sell or hold the shares of the newly formed publicly traded entity. These spin-offs can create opportunities for careful Investors. Why Do Companies Undergo Spin-Off Transactions? A good practice for most corporations is to periodically conduct a strategic review of the portfolios of their business units. Through this review process, a company may identify a business segment that no longer makes sense to own. Those reasons include a lack of synergies with other divisions, differing growth rates among various segments and the belief that investors are not valuing certain businesses correctly. The next decision is whether to sell the business outright to a financial or strategic buyer or to spin it off into its own publicly traded entity. The benefit of an outright sale is that the value created is more certain once a purchase price is agreed upon. Spin-offs, on the other hand, get favorable tax treatment under Section 355 of the Internal Revenue Code. Per this regulation, shareholders do not have to pay tax on the newly distributed shares and the parent company doesn’t have to pay any taxes, either. If the parent company has owned the business it wants to spin off for a long time, it likely would have a high tax bill at the sale, making the decision of whether to spin off or to sell that much easier. Why Do Spin-Offs on Average Outperform the Market? As the accompanying chart shows, the Bloomberg Spin Index has outperformed the S&P 500 Total Return Index by 1.5% per year over the past 20 years. One of Charlie Munger’s (Warren Buffet’s right-hand man) top three pieces of investment advice is to “carefully study spinoffs.” With this type of long-term track record of outperformance, we tend to agree.

Over our careers, we have observed several reasons why spin-offs have outperformed and why, in our view, this outperformance can be sustained. Among them: • When a company is spun out of a larger company, the smaller company often lands in the hands of investors who are hired to own shares of large companies. Thus, when these investors receive the shares of the smaller company, they sell their shares en masse merely because the spin-off company does not fit their assigned investment mandate. This indiscriminate selling can create a temporary but significant mispricing or market inefficiency between the intrinsic value of the company and where the stock is trading, creating opportunities for investors who may be more patient and discerning. • Spin-offs are commonly under-appreciated (and perhaps under-managed) within a larger company. Once they are spun off, however, the new companies can be accompanied by more focused management teams motivated to drive stronger growth and/or margin performance. • Many spin-offs ultimately are acquired at a premium to compensate existing shareholders for future returns that they may forgo by agreeing to allow the business to be sold. To preserve the tax-free status of the spin-off as noted earlier, shares of a spin-off must stand alone for two years. After that, they are generally free to be sold to the highest bidder. Spin-offs are not without risks, which is why we place emphasis on the “carefully” part of Munger’s quote. Sometimes a company wants to spin off a business because it has a challenging growth outlook or to cordon off a legal liability from the larger entity. The company can also use a spin-off to improve its balance sheet while leaving the spin-off with a suffocating amount of debt. Additionally, given the historical outperformance of spinoffs, more investors may be analyzing spin-offs than in the past.