During my days as a financial advisor years ago, I once visited a client with a real conundrum.

Apparently, she had been working to get her financial affairs in order after a divorce. The good news is that while combing through some file folders, she came across a stack of old stock certificates giving her a large stake in Allstate (NYSE: ALL) and Dean Witter, Discover & Company.

The bad news? She hadn’t ever bought them and wasn’t sure where they came from.

After doing a little homework, I found that they were both essentially gifts from Sears (Nasdaq: SHLD) — of which she had been a longtime shareholder. You see, Sears had acquired brokerage firm Dean Witter in 1981 and introduced the Discover (NYSE: DFS) credit card to shoppers just a few years later.

In 1993, the retailer decided to sell 20% of its ownership in Dean Witter, Discover & Co. through an IPO (raising $900 million), and the other 80% was handed over to shareholders through a spinoff. Soon after, Sears did the exact same thing with Allstate.

So instead of one stock, my client now owned three. And unlike many investors, she was smart enough to hang on to them. I say that because spinoffs can be an easy source of profits.

Renowned money manager Joel Greenblatt wrote the book on spinoffs — literally. His best-seller, You Can be a Stock Market Genius is one of the definitive works on the subject. Greenblatt is no ivory tower academic. The former Gotham Capital hedge fund manager and Warren Buffett devotee has racked up annualized returns of +40% during the past two decades.

Head Spinning Profits
Quick question: What do Lucent Technologies (NYSE: LU), American Express (NYSE: AXP) and Yum Brands (NYSE: YUM) all have in common?

On the surface, not too much. But at one point in their history, each of these firms was spun-off from a larger parent company. And eagle-eyed investors are always on the lookout for these deals because corporate spinoffs have proven to be fertile ground. In fact, some pros devote their careers exclusively to these transactions and nothing else.

It’s easy to see why. In 1999, consulting firm McKinsey conducted a comprehensive study of 168 restructurings during the prior 10 year period. They found that shares of the spinoffs produced annualized gains of +27% in the 24 months following separation, versus +17% for the S&P 500.

That performance could have turned a $10,000 investment into more than $109,000 over 10 years against just $48,000 in an index fund. That figure is just for the group as a whole — no effort was made to identify the best-positioned spinoffs with the most potential.

Aside from the McKinsey study mentioned above, there have been several others that reached the same conclusion. Lehman Brothers found that spinoffs have an edge of more than +13%. The numbers aren’t skewed by just a handful of big winners. In fact, between 2003 and 2006, two-thirds of all spinoffs outperformed the market.

Not bad for buying businesses that were essentially amputated.

Why Do Companies Spin?
Spinoffs occur when a large parent company decides to cut loose a subsidiary or division and refocus its core operations.

These deals are done for a number of reasons. In some cases, the intent might be to offload debt or sever ties with unprofitable units that aren’t carrying their weight. You probably want to steer clear of these. But at other times, the spinoff is necessary to satisfy anti-trust requirements or resolve friction and conflicts of interest between a subsidiary and parent.

Perhaps the most promising situations arise when a fast-growing business is being held back and simply needs to be set free.

Management could always sell off the assets, but then the proceeds would be taxable. By contrast, spinoffs are typically considered a tax-free distribution of shares.

For example, armored car transport provider Brinks decided to carve out its home security division. So in 2008, the assets were folded into a new, standalone business called Brink’s Home Security Holdings and given to current stockholders on a 1-1 basis — anyone holding 10 shares of Brinks was handed 10 shares of Brinks Home Security Holdings.

True to form, shares of the new company (which has since changed its name to Broadview Security) have already doubled, climbing from $20 shortly after the spinoff to about $40.

1 + 1 = 3
Remember, the sum of the parts can often be worth more than the whole.

Picture a large conglomerate with a dozen different segments and $5 billion in annual earnings. Under that wide umbrella, there might be a small, booming business with profits of maybe $10 million. Unfortunately, no matter how bright its prospects, the smaller subsidiary will always get lost in the shadow of the parent.

Even a +100% surge in earnings would only move the parent’s needle just 0.2%. So Wall Street can’t pin an accurate price tag on the business because investors are far more concerned with what the other $5 billion is doing.

But as a standalone pure-play, the company might finally get the respect it deserves.

Pent-Up Entrepreneurial Forces
Companies that are spun-off also tend to be overachievers — if for no other reason, the new firm’s leaders are now free from bureaucracy and sitting on a bundle in stock option incentives.

Greenblatt refers to this magical time as the unleashing of “pent-up entrepreneurial forces.” But here’s the real beauty: most investors don’t flock to spinoffs. In fact, they do just the opposite and unload the new shares the first chance they get. There are several reasons for this.

Smaller investors sometimes see the distribution as something akin to a dividend, so they sell the new shares to raise cash and often reinvest back in the parent company. Institutional holders aren’t any better. Their primary interest is the parent company, not a small (and generally unknown) side venture.

Against this indiscriminate selling, spinoffs often struggle in their first year for reasons that may have nothing to do with the underlying company. That’s usually a good time to act, because sooner or later the new company will get to tell its story. If that story is a good one, Wall Street will respond.

Of course, you’ll still need to do your homework. After all, some companies were discarded just because they weren’t worth keeping. But many others will go on to do great things once they leave the nest.

P.S. Market leader Expedia (Nasdaq: EXPE) was another of these profitable spinoffs. The stock is a current holding in my  Market Advisor Growth Portfolio — returning +99.8% in only 18 months. And Expedia wasn’t my last big winner. In March, I profiled TimeWarner Cable (NYSE: TWC) after its spinoff from parent company, AOL and it returned +17.3% in just six weeks.

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