When one company buys another, shareholders often get a bad deal. That’s frequently because the buyer pays too much. Spin-offs – when a company decides to float an existing part of its business as a separate company on the stock exchange – are a different kettle of fish. Evidence suggests that spin-offs can be very good investments.

The strategy of investing in spin-offs is covered in investing guru Joel Greenblatt’s book You Can Be A Stock Market Genius . According to him, one of the secrets to getting good returns on shares is to look where not many others do. And he thinks spin-offs are fertile hunting grounds for bargains.

Why companies spin off divisions

The main reason why companies decide to spin off a part of their business is to allow the stockmarket to get a better appreciation of what remains. Sometimes a company has too many different activities which can give the impression – or reflect the reality – that it is unfocused and not as effective as it should be. If a company has fingers in too many pies, investors may think it is a ‘jack of all trades and master of none’.

This problem was particularly common in the 1970s and 1980s when there were a lot of conglomerates listed on the stockmarket. Their shares were often undervalued compared to what they were really worth – known as a ‘conglomerate discount’.

By cleaning up the structure of the company, investors should be able to tell the wood from the trees. This, in theory, should lead to a higher stockmarket value for the business.

Spin-offs are also a way of getting rid of bad businesses or ones that are difficult to sell on. Often these spin-off businesses are loaded up with debt so that the remaining (better) business can have less debt and look more attractive to investors.

Should you buy the shares?

Shares in spin-offs are usually given to the existing shareholders of the larger company. Quite often, large professional investors who receive these shares will sell them immediately. As spin-offs tend to have a lower market capitalisation than the parent company, they are often too small for institutional investors who like to invest in larger, more liquid shares.

A wave of selling by institutional shareholders can drive the share price of the spin-off down to very attractive levels – a good starting point for making money.

Another reason why spin-offs tend to succeed is that the management of the spin-off is freed from the shackles that often come with working for a much bigger organisation. More often than not, the managers are incentivised with juicy share options that can make them very rich if the company does well.

Another point to bear in mind is that sometimes spin-offs take a while to be included in stockmarket indices. So, buying before they go in can lead to a nice gain when all the tracker funds have to buy the shares.

There have been a number of studies on the performance of spin-offs. The Greenblatt book cites a 25-year study from 1963 to 1988, where the new companies’ shares outperformed the S&P 500 by 10% per year in their first three years of independence. The parent companies also outperformed by an average of 6% per year.

Not all spin-offs are guaranteed to do well, but there have been some notable successes in recent years. TripAdvisor (Nasdaq: TRIP ). which was spun out of Expedia in late 2011, has outperformed the S&P 500 by a whopping 191% in share price terms since then.

AbbVie (NYSE: ABBV ). which was carved out of Abbott Laboratories at the beginning of 2013, has outperformed the S&P 500 by 37% since it came to the market.

Five to watch out for

It looks like there will be a lot more spin-offs to come in the next year or two. One way to buy into them is to invest in an ETF. The Guggenheim Spin-Off ETF (NYSE Arca: CSD ) invests in a basket of spin-offs and sells them after owning them for 30 months.

This fund has outperformed the S&P 500 by 45% since 2006, but can be quite volatile. It has lagged the S&P 500 this year. This may not be the easiest fund to buy and comes with an annual expense ratio of 0.65%.

The bid-offer spread (the difference between the buying and the selling price) can be quite high and might put some people off.

A better and cheaper way is to read the financial press and keep a lookout for impending spin-offs. I’ve created a table of a few possible spin-offs on the left.

A spin-off of PayPal by eBay would be very interesting. PayPal is likely to be valued very highly, given its large number of account holders and the growth potential of mobile payment technology.

As PayPal has arguably been making up an increasing chunk of eBay’s total value, this could leave shares in the stand-alone eBay company looking quite cheap, and could be a reason to buy them rather than the PayPal spin-off.

Parent company

Probable/possible spin-off