Analyzing Special Situations
A global study conducted by consulting firm The Edge and accounting firm Deloitte examined 385 global spin offs involving parent companies with a market cap of $250 million or more from January 2000 to June 2014. To qualify, transactions had to be pure spinoffs, with parent company shareholders receiving shares in newly listed companies. The study discovered that during their first twelve months independent of the parent, the global asset class of spinoffs generated more than ten times the average gains of the MSCI World Index.
Consumer, health-care, utility, and energy sectors delivered the best results. Importantly, value creation was independent of economic growth or analyst coverage of the company. Within two years, two out of every ten spin-offs were acquired or taken private.
The performance of spinoffs in India is even more impressive. SBI Capital examined 154 spinoff transactions in India from 2002 to 2016 and demonstrated how spinoffs outperform broader market indices across market cycles. According to their research, spinoffs generate an average excess return of around 36% over the market index (Sensex).
When a promising but small-cap company demerged from a large-cap parent is listed and has residual institutional holding, a profitable opportunity often arises. During the first few weeks and months of trading, you will frequently see forced selling by institutions that are unable to hold the new stock in their portfolios due to certain rigid institutional mandates, such as being allowed to invest only in certain sectors or having market cap restrictions, and you will end up with significant paper losses on your existing holdings of the demerged company's shares.
Spinoffs are live case studies in time arbitrage, in which the patient investor is compensated for simply waiting and allowing the procedural formalities to play out.
In India, a demerger typically consists of six steps:
(1) Board approval
(2) Stock exchange approval
(3) Secured and unsecured creditors' and shareholders' approval
(4) National Company Law Tribunal final approval
(5) Record date announcement by the board
(6) Listing of the demerged entity
When the listed conglomerate entity trades at a low valuation multiple, some of the most profitable demerger opportunities arise. However, once separated, the demerged entities would have traded at a much higher multiple, which is sometimes based on completely different valuation parameters than the currently listed parent entity.
Greenblatt then goes over five reasons why a parent might spin off a subsidiary:
- Conglomerates typically trade at a "conglomerate discount." Management can "unlock" value by separating unrelated businesses. In other words, the total of the parts is greater than the sum of the parts.
- To distinguish between a "bad" and a "good" business.
- To generate value for a subsidiary that cannot be easily sold.
- To recognise value while avoiding a large tax bill that would be incurred if the parent company pursued a sale rather than a spinoff.
- To overcome a regulatory hurdle. A company, for example, may be in the process of being acquired. To address antitrust concerns, it may need to spin off a subsidiary.