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 Part III
(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)
Check out our H2 hedge fund letters here.
Peter Lynch is another legendary investor that is a proponent of investing in spinoffs. Lynch managed Fidelity’s Magellan Fund from 1977 to 1990. During that period, assets grew from $20 million to $14 billion and he generated annual returns of 29%. Pretty incredible.
In Lynch’s investing classic, One Up on Wall Street, he mentions spinoffs as an area where he looks for potential opportunities. We have covered many of the points that Lynch makes, but they are still worthwhile to underscore.
Lynch begins, “Spinoffs often result in astoundingly lucrative investments.”
He believes parent companies do not want to spin off divisions that will go on to fail as this would reflect poorly on the parent. Lynch also notes, “And once these companies are granted their independence, the new management, free to run its own show, can cut costs and take creative measures that improve the near-term and long-term earnings.”
Spinoffs get little attention from Wall Street and they are usually misunderstood by investors. This all bodes well for future returns. Lynch believes spinoffs “are a fertile area for amateur shareholders.” Lynch recommends looking for spinoffs with insider buying as it will confirm management believes in the spinoff’s long term potential.
Lynch then dives into a brief case study of the breakup of AT&T. Lynch writes: “The greatest spinoffs of all were the ‘Baby Bell’ companies that were created in the breakup of AT&T: Ameritech, Bell Atlantic, Bell South, Nynex, Pacific Telesis, Southwestern Bell, and US West. While the parent has been an uninspiring performer, the average gain from stock in the seven newly created companies was 114% from November 1983 to October 1988. Add in dividends and the total return is more like 170%. This beats the market twice around, and it beats the majority of all known mutual funds, including the one run by yours truly.”
Once liberated, the seven regional companies were able to increase earnings, cut costs, and enjoy higher profits. They got all the local and regional telephone business, the yellow pages, along with 50 cents for every $1 generated by ATT.”
- 300+ Book Recommendations From Mohnish Pabrai –
- Pabrai Flagship Returns 92 Percent In 2017; 14X Return On Indian Small-Cap
- Mohnish Pabrai On Hidden Value Home run
Pabrai is Founder of Pabrai Funds and is a relatively new kid on the value investor / special situations block. While Mohnish is not in the same league as Buffett, Munger, Klarman, Greenblatt, and Lynch, he has an enviable track record with annual returns of ~14% (from what I could find online) from 2000 to 2017. In November 2017, Pabrai published an article in Forbes called “Spin Gold From Spinoffs: A Portfolio of 5 Castoffs Trounces the S&P 500.”
Pabrai writes: “Too often, shareholders shrug off spinoffs and sell the spinoff shares promptly upon receipt. Institutional investors in particular sell spinoff shares because they are either not allowed to own stocks below a certain market cap or they simply don’t understand the new spun out business. This leaves money on the table and creates selling pressure in the first few quarters after the spinoff. It is therefore a good idea to invest in spinoffs after they have been around for a few quarters.”
The purpose of Pabrai’s article was to determine if spinoffs still outperform. He writes, “We decided to backtest how spinoffs have performed since Greenblatt spilled the beans on the many advantages of spinoff investing.” Pabrai built The Spinoff Portfolio by following the below rules to narrow the universe and select spinoffs that are most likely to succeed:
- Pabrai noted that spinoffs tend to perform the best between years 1 and 7, thus, spinoff stocks in the Spinoff Portfolio were added after a year and sold after 7 years.
- The Spinoff Portfolio only added spinoffs that had 70% of their floats in the market. Partial spinoffs were not included.
- Price to sales of less than 3.
- Minimum market cap of $100mm.
- If the spinoff company is less than 5 years old, then it can only be included if its parent company has a credit rating equal to BB+ by S&P or Fitch or EJR, or Ba1 by Moody’s.
In terms of mechanics, The Spinoff Portfolio bought the youngest five spinoffs (20% of portfolio in each name) starting in 2000 that met the above criteria. Each year the portfolio is rebalanced. The old companies that no longer meet the criteria are sold, and the “sell money” is redistributed evenly into the new companies that meet the criteria.
How did it do?
From 2000 through November 15, 2017, the spinoff portfolio generated a total cumulative return of 789.2% versus the S&P 500 return of 146.8%. On an annualized basis, the Spinoff Portfolio generated a 13.1% return versus the S&P 500 at 5.2%. Not bad!
Even better, Pabrai will publish the Spinoff Portfolio every year on his blog www.chaiwithpabrai.com.
I know there are many Superinvestors that I have missed, and I will continue to update this article periodically with additional profiles. If you have any recommendations of other spinoff Superinvestors who you would like to see profiled, please let me know in the comments below.
As always, thanks for reading!
I have 6 years of public equity research experience and 5 years of private equity experience - SpinoffInvesting