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Your 2-Step Guide To Spin-Off Investing -- And 3 Picks To Get Started

Tuesday, March 18, 2014 2:30 PM

We've come a long way from the era of conglomerates. Decades ago, management teams figured that if they can run one business well, they can run any business well.

As a result, they'd acquire a collection of unrelated businesses, convincing investors that exposure to a wide range of businesses would help smooth out the impacts of economic cycles.

It was a silly notion, and as dubious investors began to apply a "conglomerate discount" to any companies that were too unwieldy to analyze, the long process of de-conglomerating began, These days, fewer conglomerates exist, but when one of them announces a plan to sell or spin-off a large division, investors invariably cheer.

Just this week, we saw the trend in action: News reports suggest that auto rental firm Hertz Global (NYSE: HTZ) will separate its equipment rental business, which is estimated to be worth around $4.5 billion. Shares rose more than 5% on the news.

Frankly, investors have developed a Pavlovian response to spin-offs and asset sales, as they note the amazing returns such a move can generate. The Guggenheim Spin-Off ETF (NYSE: CSD) has risen a stunning 350% over the past five years while the S&P 500 has risen merely 150%.

That fund buys shares based on an index that tracks recent spin-offs. For example, its top two holdings, WhiteWave Foods (NYSE: WWAV) and Trip Advisor (Nasdaq: TRIP), are each up more than 60% in the past year.

Yet investors don't need to wait until a spin-off happens. Instead it's wiser to deploy a two-phase trading strategy.

First, buy the parent company if you a sense that a spin-off announcement is coming (or has been recently made). Hold tight through the spin-off period, owning shares of both the parent and the spin-off when the process is complete.

Typically, a parent company will fall in value (simply to reflect the lost value of the spun-off entity), but the parent will rise in value from there as management starts to explain the sharpened fiscal strength of the slimmed-down parent. You can sell that parent when shares rise to reflect the brighter outlook.

Then, you can focus on the spin-off, which often takes longer to reach its potential due to a short track record. Shares of WhiteWave and TripAdvisor, for example, initially traded weakly after the spin-off but then took off like a rocket once they began delivering solid stand-alone results.

Despite the quick share price gain for Hertz this week, analysts think shares can move up into the low $30s from a recent $27. Analysts at Deutsche Bank have a "strong sense is that a spin-off of (the equipment division) would be well-received by investors (particularly if it can be accomplished in a manner that optimizes the tax treatment)."

Analysts at MKM Partners think the "enables both entities to focus on their own clear strategic priorities and capital requirements; (2) improves transparency of both businesses; and (3) enables RAC (car rental) to potentially undertake a levered recap." That last point suggests a strategy that many companies employ after a spin-off: Take up debt after some existing debt has been saddled with the spin-off. And higher debt can fuel buybacks, dividend hikes or acquisitions.

Know What You Own
To be sure, investors need to assess the appeal of both the parent company and the targeted spin-off. Hertz's equipment rental division is performing well, and the division should see solid leverage from an expected upturn in industrial and construction activity in the U.S.

But companies sometimes spin out duds that end up burning investors. 3M (NYSE: MMM) unloaded its magnetic tape division Imation (NYSE: IMN) in 1996. A year earlier, the division had $2.2 billion in sales but was losing money. The company has been shrinking ever since, with sales expected to fall to $600 million next year -- and it's still losing money.

There are a few dozen companies in the S&P 500 that might look to pursue a spin-off in the next 12 to 18 months. Here's a quick sample of the potential spin-offs to come.

1. General Electric (NYSE: GE)
This conglomerate needs a financing arm to help its industrial customers secure leases for massive jet turbines and other multi-million-dollar products. But GE's consumer finance division has no place in the company's firmament.

Indeed the company's dual image as an industrialist and financier has been the worst of both worlds as investors perpetually wrestle with the company's core profitability. Something needs to be done. As I noted last month, CEO Jeff Immelt has not created any shareholder value in his 12-year tenure.

2. Rayonier (NYSE: RYN)
This stock got a nice boost in January when plans were announced to spin off its high-performance fibers business later this year. As I wrote back in 2012, "Rayonier has had strong gains in its performance fibers division, as the company's cellulose fibers are seeing an increasing number of industrial applications. The company's 2012 production capacity has already been sold out, and a new facility in Georgia is likely to also sell out its production capacity. This capacity makes Rayonier the largest producer of high-performance fibers in the world."

Still, shares are well below their 52-week high, and further clarity on what each entity will look like after the spin-off is complete might help investor sentiment.

Rayonier currently sports a 4.3% dividend yield, and at this time, it is assumed that the spun-off business won't offer a yield. The remaining core lumber/real estate business is likely to maintain the real estate investment trust (REIT) status.

3. Occidental Petroleum (NYSE: OXY)
This energy exploration firm has been dogged for years by accusations of ineffectual management, but times are changing. Wall Street analysts think management is now more attuned to shareholder concerns, reflected in efforts to unload the company's California assets, which should happen by the end of 2014 or early 2015.

Analysts at Goldman Sachs think "the separation of California (exploration and production) in particular will help investors better understand the growth/returns characteristics of this unique E&P business," adding that the company's impressive base of assets remains under-appreciated. "The assets are likely to be better appreciated by investors when run under a more typical E&P business model that focuses on volume growth and (earnings) generation rather than as part of a major oil company." When the process is complete, they see shares rising from a recent $96 to $119.

Risks to Consider: As we saw with the 3M example, some spin-offs are merely an effort to unload a troubled division, so it's crucial that the asset being put into play is in good health.

Action to Take --> As noted, the spin-offs take some time to gain traction as they need to build a following. So this isn't a quick-trade strategy. You need to stick around for a while to let both the parent and spin-off reach full value.

P.S. When a parent company slims down through a spin-off, it can emerge as an even stronger -- and more shareholder-friendly -- entity than before. These are the kind of investments my colleague Dave Forest looks for every day in his premium advisory Top 10 Stocks. To learn more about his latest investment ideas, including several names and ticker symbols, visit this link.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.