Article by Richie, Stock Spinoff Investing
Superinvestors and Stock Spinoffs: What Buffett, Munger, Klarman, Greenblatt, Lynch, and Pabrai Have to Say about Investing in Spinoffs
(This article was originally published in February 2016, but I wanted to update it to add Warren Buffett and Mohnish Pabrai’s perspective on spinoffs – stay tuned for Parts II and III)
Charlie Munger on Discount Rates and Opportunity Cost
Discounting future cash flows is one of the most frequently used methods of business valuation. It's also the preferred method of Warren Buffett and Charlie Munger. If you’re looking for value stocks, and exclusive access to value-focused hedge fund managers, check out Hidden Value Stocks. While he's never laid out his exact valuation process, Buffett Read More
Check out our H2 hedge fund letters here.
I’ve known for a while that many of the world’s Superinvestors advocate investing in spinoffs. After all, that’s one of the reasons why I originally became interested in researching spinoffs.
While there are many, relatively brief articles around the internet that summarize what Greenblatt, Munger and other Superinvestors have said about spinoffs, I struggled to find an all-encompassing resource. The goal with this article is to create one.
With that, let’s dive in….
What better Superinvestor to start with than Warren Buffett? Buffett needs no introduction, but I will provide one anyway. He is broadly recognized as the best investor of all time. From 1957 to 1969, Buffett ran an investment partnership which compounded at 29.5% annually. From 1965 (the time of Buffett’s initial investment) to 2017, Berkshire Hathaway‘s share price has compounded at 20.9% annually.
Buffett has an interesting perspective on spinoffs. In his early years managing his partnership, Buffett did invest in spinoffs. Buffett categorized his partnership’s investments into four different groups: 1) Generals – Private Owner Basis 2) Generals – Relatively Undervalued 3) Workouts and 4) Controls. Here is what Buffett wrote about workouts:
“These are securities with a timetable. They arise from corporate activity – sell outs, mergers, reorganizations, spinoffs, etc. In this category we are not talking about rumors or ‘inside information’ pertaining to such developments, but to publically announced activities of this sort. We wait until we can read it in the paper.”
Unfortunately, Buffett doesn’t dive any deeper into his strategies regarding spinoffs, but we do know that he invested 23% of his Partnership portfolio in workouts (which included spinoffs) in 1969.
Does Berkshire Hathaway invest in spinoffs today? Yes – most definitely.
Just look at Berkshire’s current portfolio (as of 12/31/17) which includes Phillips 66 (ConocoPhillips spinoff), Synchrony Financial (General Electric spinoff), and Moody’s Investors Service (Dun & Bradstreet spinoff), Seritage Growth Properties (Sears spinoff), and all the Liberty Global spinoffs in the Berkshire portfolio.
Would Berkshire itself spin off any of its subsidiaries? To answer that question, it’s helpful to re-read Buffett’s 2014 letter to shareholders. Buffett explains in the letter that despite the poor reputation of the conglomerate structure among investors, it is an ideal structure for Berkshire:
“Conglomerates, it should be acknowledged, have a terrible reputation with investors. And they richly deserve it…..So what do Charlie and I find so attractive about Berkshire’s conglomerate structure? To put the case simply: If the conglomerate form is used judiciously, it is an ideal structure for maximizing long-term capital growth……At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry…..Another major advantage we possess is the ability to buy pieces of wonderful businesses – a.k.a. common stocks. That’s not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful; a broad range of options always sharpens decision-making. The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety. Additionally, the gains we’ve realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.”
Later in the letter, Buffett directly addresses whether it would ever make sense to spin off Berkshire subsidiaries:
“Sometimes pundits propose that Berkshire spin-off certain of its businesses. These suggestions make no sense. Our companies are worth more as part of Berkshire than as separate entities. One reason is our ability to move funds between businesses or into new ventures instantly and without tax. In addition, certain costs duplicate themselves, in full or part, if operations are separated. Here’s the most obvious example: Berkshire incurs nominal costs for its single board of directors; were our dozens of subsidiaries to be split off, the overall cost for directors would soar. So, too, would regulatory and administration expenditures.
Finally, there are sometimes important tax efficiencies for Subsidiary A because we own Subsidiary B. For example, certain tax credits that are available to our utilities are currently realizable only because we generate huge amounts of taxable income at other Berkshire operations. That gives Berkshire Hathaway Energy a major advantage over most public-utility companies in developing wind and solar projects.
Investment bankers, being paid as they are for action, constantly urge acquirers to pay 20% to 50% premiums over market price for publicly-held businesses. The bankers tell the buyer that the premium is justified for “control value” and for the wonderful things that are going to happen once the acquirer’s CEO takes charge. (What acquisition-hungry manager will challenge that assertion?) A few years later, bankers – bearing straight faces – again appear and just as earnestly urge spinning off the earlier acquisition in order to “unlock shareholder value.” Spin-offs, of course, strip the owning company of its purported “control value” without any compensating payment. The bankers explain that the spun-off company will flourish because its management will be more entrepreneurial, having been freed from the smothering bureaucracy of the parent company. (So much for that talented CEO we met earlier.)
If the divesting company later wishes to reacquire the spun-off operation, it presumably would again be urged by its bankers to pay a hefty “control” premium for the privilege. (Mental “flexibility” of this sort by the banking fraternity has prompted the saying that fees too often lead to transactions rather than transactions leading to fees.) It’s possible, of course, that someday a spin-off or sale at Berkshire would be required by regulators. Berkshire carried out such a spin-off in 1979, when new regulations for bank holding companies forced us to divest a bank we owned in Rockford, Illinois.
Voluntary spin-offs, though, make no sense for us: We would lose control value, capital-allocation flexibility and, in some cases, important tax advantages. The CEOs who brilliantly run our subsidiaries now would have difficulty in being as effective if running a spun-off operation, given the operating and financial advantages derived from Berkshire’s ownership. Moreover, the parent and the spun-off operations, once separated, would likely incur moderately greater costs than existed when they were combined.”
While Buffett cites control value and tax advantageous as important benefits of the conglomerate structure for Berkshire, the far and away most important benefit is capital allocation flexibility. The conglomerate structure enables Buffett, the world’s best capital allocator, to allocate the billions of dollars in cash that Berkshire generates every year. This has worked very well for Berkshire shareholders over the past fifty-two years as evidenced by the stock’s 20.9% annual return during that period.
So to conclude, Buffett does like to invest in spinoffs but is unlikely to spin off any Berkshire subsidiaries unless required to do so for regulatory reasons.
Charlie Munger is Vice Chairman of Berkshire Hathaway and Warren Buffett’s right hand man. Buffett’s original strategy was to invest in “cigar-butt” stocks. If one is able to buy a stock very cheaply, it is “like picking up a discarded cigar-butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.”
Buffet credits Munger with breaking his “cigar-butt” investing strategy:
“My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance… But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well. In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise. Selecting a marriage partner clearly requires more demanding criteria than does dating.”
“…It took Charlie Munger to break my cigar-butt habits and set the course for building a business that could combine huge size with satisfactory profits…. From my perspective, though, Charlie’s most important architectural feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices….Consequently, Berkshire has been built to Charlie’s blueprint.”
What does Charlie Munge think of spinoffs? On June 25, 2008, Mohnish Pabrai and Guy Spier paid $650,100 to have lunch with Warren Buffett and Charlie Munger.
Their lunch has been widely reported in the press. The three recommendations that Charlie Munger shared with Pabrai were the following:
- Carefully look at what other investors have done. This includes following 13F filings of great investors.
- Look at cannibals, companies that are buying back a ton of their own stock.
- Carefully study spinoffs.
Besides this story, I haven’t been able to find much additional insight into Munger’s thoughts on spinoffs. However, I find it pretty interesting and notable that one of Munger’s top three recommendations is to “carefully study spinoffs.” Given this advice, it is not surprising that Berkshire’s investment portfolio has a healthy allocation to spinoffs.
I have 6 years of public equity research experience and 5 years of private equity experience - SpinoffInvesting