~10% Historical yearly outperformance by Spinoffs

Background:
I recently gave a presentation looking at Spinoffs and their historical large excess returns, looking at what factors seemed to be important to construct a portfolio of a subset of the spinoff industry. I thought it might be interesting for the more research-based investors among us.

Introduction
A spin-off is when a company (parent) creates a new company by selling or distributing new shares of its existing business, it’s a type of divesture. (Investopedia paraphrase + some added info).

This subset of companies (both parent and child) seem to have outperformed the market consistently historically, and the child’s performance was phenomenal over the last half century.


(Purdue university study which was renewed and issue from 1993 journal of financial economics)

It was found those child companies (the spun-off company) really outperformed so it might be interesting for research-driven investors to know why this happens so consistently and how to profit from this phenomenom. Especially the excess return in the first three years is strong.

Explanation of outperformance
According to multiple papers and research articles it seems that the Congomerate discount is responsible for some of the outperformance.

Historically conglomerates trade at a ~10% discount to their pure play peers (Spin-offs: Tackling the Conglomerate Discount). Conglomerates (execpt those in Latin America and Japan) trade at a discount because they’re more inneficent, less transparent and don’t achieve all benefits for shareholders that they could. This largely is due to the diffrence in growth profiles of divisions and these must compete for limited capital, this results in high growth divisions finding themselves at a comparative disadvantage to the the larger and more established divisions within a conglomerate. This discount being priced in again could explain some of the outperformance during the initial three years after the spin off.

See figure below.

This discount has persisted (the 10 year period represented below is a very short time period in financial research which must be noted) and thus seems to support that conglomerates invest more ineffiecntly but have potential value to be unlocked.

When spinning of the child can allocate capital better, focus on it’s core business and be more transparent (in conglomerates there is division reporting but not to the detail as with which a public child would disclose). It can be said that (most) investors like higher returns on investment and transparency.

Fun fact: Spin-offs lead to an improved valuation multiple for the parent as well
(I’m very funny at parties)


Instead of putting a Warren Buffet concentration builds wealth I choose an interesting quote by Sun Tzu, there seem to be certain factors within spin-offs that improve performance as well let’s take a look!

Subsets of spinoffs
In research conducted by Matthew Semandeni and Alber Cannella found that continued ownership by the parent firm has a negative effect on the child firm market performance

The parent retains ownership because it believes the child stock will appreciate and therefore it has an interest in the child’s success, leading to a positive relationship between parent ownership and performance but the parent often retains the ownership to exert continued control over the child, and that this continued control would negatively affect performance as proved by M. Semandeni and A. Cannella.

Another interesting finding is that having either a board member or a chairman of the board from the parent firm has essentially the same positive effect on the child firm’s market performance. But having both a board member and chairman from parent has a negative effect.

The above is also related to control by the parent firm, it seems that a little bit spurs better performance but more has a negative result.

Also having ties form the parent when previously vertically integrated or horizontally related seems to have a positive effect on the child performance.

Just so you know:
Horizontal: same industry and at the same stage of production
Vertical: same industry but different production stage


There are a lot of ways to seperate bussines, as highlighed in the slide above, if you’re interested in the other strategies I would suggest you read Spin‐offs: Tackling the Conglomerate Discount (Ajay Khorana, Anil Shivdasani, Carsten Stendevad, Sergey Sanzhar, Citi) or find more research going into more depth on your topic of interest!

Bellow some of the spinoffs expected this year (VODs Vantage Towers already is next week)

Hope it was an interesting read and let me know what your thoughts are!

Sources

Note: I didn’t put links to the articles as a lot of people don’t have access to those databases so if you can’t find it yourself I can share the papers if you want :wink:
Academic:
Spin‐offs: Tackling the Conglomerate Discount (Ajay Khorana, Anil Shivdasani, Carsten Stendevad, Sergey Sanzhar, Citi)

Examining the performance effects of post spin‐off links to parent firms: should the apron strings be cut? (Matthew Semadeni Albert A. Cannella JR)

Spin-Off Performance: A Case of Overstated Expectations? (Carolyn Y. Woo, Gary E. Willard and Urs. S. Daellenbach)

Drivers of spin-off performance in industry clusters: Embodied knowledge or embedded firms? (Guido Buenstorf, Carla Costa)

Non-academic:

How Spinoffs Shares Outperform the Market Index

7 Stock Spinoffs to Watch in 2021

Disclaimer: I own several spinoffs (although not recent ones) like Aperam, Abbvie and hold MRK directly which will spin off Organon. Also hold shares in Ecolab which split off Champion X

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Thanks for the article. I always found it interesting that internal competition of a very diverse company/conglomerate would be rated as a negative impact even though that very competition between divisions can lead to more refined and cost-effective plans being chosen. I would have thought that the discount impact would have been more than 10%, say around the 15% range.

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the conglomerate discount varies widely per region:

And conglomerates tend to reduce the discount in turbulent years as investors like diversification in those times (see big increases around .com and gfc) so in very uncertain times/regions the discount can turn into a premium

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Interesting read. Fingers crossed the GSK spin off will go the same way as Abbott and AbbVie.

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Only time will tell :stuck_out_tongue_winking_eye:

Yes I hold GSK and next big thing for me is how the spinoff goes as thats also when the dividend will change so will keep a close eye on if my thesis for them has changed.

Thank you for such an interesting analysis and commentary Etypsyno.

I guess this makes sense as some Latin American countries have been perceived as more risky politically in the last two decades, for example Argentina, and in risky jurisdictions you probable are safer investing in large and robust conglomerates with stable cash to face periods of uncertainty. Whereas smaller companies may be riskier.
I guess that if these countries become more stable then the conglomerate premium may become a discount…

I have a couple of questions or points for discussion if anyone fancies answering :smiley:

Questions:

  1. How are excess return measured? Are they compared to the return from the particular industry or the broad national market?

Discussion:

  1. Do we think that the conglomerate discount is enough to explain such differences in long-term performance? What could explain any subsequent excess return, beyond say the first 5 years?
    I understand if medium term, say 1-5 years it explains the difference in returns, but I cannot see how a 10% discount could explain such impressive outperformance, as Etypsyno states:
  1. The outperformance of spin-offs has been known for quite a long time. For example, Peter Lynch’s book “One Up on Wall Street”, first published in 1989 already claimed that spin-offs “often result in astoundingly lucrative investments” (Pg. 133).
    He attributed this to large parent companies not wanting to spin off divisions and then see those spin offs go into trouble as that would be a public embarrassment, therefore spin offs are provided with a strong balance sheet which combined with aggressive cost cutting and creativity can lead to much larger earnings.
    However, I don’t see how this could be have a long term effect. And more importantly, if this has been known for over 30 years (it’s quite a popular book and I imagine that others have commented on the outperformance for a while too) then why is it still present in the data up to 2013 presented by Etypsyno? (It would be interesting to see if it is stilll present, say in 2000-2020)
    Why has the market not “caught up with this” and paid a premium for these companies?
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I don’t know the answer to all your questions but here are some of my thoughts:
1: in comparison to broad index
2 and 3 if only I knew the answers I would write my own paper :joy:

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@Etypsyno very good case study.

Do you see case for other conglomerates? E.g. Alibaba Group, Tencent Holdings, Alphabet, Microsoft.

Somehow I was hesitant to buy ABB Ltd last year.
My initial thesis of “robots only go up!” still holds…
God may be giving me another sign now. :innocent:

ABB Ltd:

"On April 27, ABB announced it has separated the
E-mobility business into its own division
and initiated a carve out into a separate legal
structure. These steps will allow for preparation for
a possible public listing and create a platform for
accelerated growth and value creation in this
business. "

JULY 22, 2021 Q2 2021 results:

“We have also made good progress
with the announced portfolio changes and I expect to
announce an agreement for a divestment during the
third quarter.”

2021-07-26

"…Furthermore, we will give an update on our plans for the Turbocharging exit and possible listing of our E-Mobility division in due course.”


My only concern is that the best place to buy them is SIX Swiss Exchange and the dividends there are 35%. Should I not overthink this detail?

Do you mean35% with-holding tax?

Also, what is the payout ratio (if at all) expected from the spinoff company?
They may not intend to give significant dividends.

@EquityInvestor Yes, that’s what I meant but somehow did not write it properly because of the late hours. :sleeping:

I would definitely not expect any dividends from their E-Mobility division since it might be in it’s infancy. Turbocharging business…maybe. :racing_car:

In that case taxes on dividends are not too important :slight_smile: .

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:money_mouth_face:

After the planned spin-off of Daimler Truck by the end of this year the shareholders of Daimler AG will hold a 65% stake in the new Daimler Truck Holding AG, which will then be listed on the stock exchange as an independent company. Daimler shareholders are to receive one additional share in Daimler Truck Holding AG, the global market leader for commercial vehicles, for every two shares they hold in Daimler AG.

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