Despite the terrible title, “You Can be a Stock Market Genius” by Joel Greenblatt is on the short list of best investment books out there- probably my favorite. Joel is the founder of Gotham Capital and one of the most influential value and special situation investors around.  I often use his value stock screening website for ideas (www.magicformulainvesting.com ) and have been heavily influenced by his investment philosophy and approach to finding opportunities.

In the “Stock Market Genius” book, Joel spends a great deal of time discussing the general investment attraction of spinoff companies, which are companies that break off from larger public companies and operate as a stand-alone public company. A couple of irritating consequences of spin-offs create a source of opportunity in Joel’s view:

• When people own a company that effects a spinoff, they tend to sell their spinoff company shares because they don’t want to take the time to evaluate a new stock and it’s usually a small position relative to their holdings in the former parent company.

• Large money managers usually don’t focus on spinoffs simply because they are smaller in size and may fall outside of their index parameters.

• Logically a parent company wouldn’t spin off and sell a piece of their business unless it was in their best interests- most investors are very hesitant to buy something that the insiders (who have way more information and insight into the business) are selling.

Joel boils it down to the idea that unlike an IPO, spinoffs are designed to give shares in a new company to people who probably don’t even want them, creating an initial negative price pressure on spinoffs that has nothing to do the quality of the company itself.

Now for the generalized bull case on Spinoffs:

1. Spinoffs often give executives a more direct opportunity to have their personal compensation relate to the success of the company itself. (An example might be if the dude who runs Frito Lay underneath Pepsi was given huge stock options in Frito as potential compensation as part of a spinoff).
2. Unburdened by a larger corporate environment, spinoffs often can be more nimble in decision making, capital allocation, and growth initiatives.
3. Parent companies usually retain a decent minority chunk of the spinoff company and have a vested interest in seeing the new company succeed. (Think of it like having a big brother that looks out for you as you start high school).

Every situation is unique and must be evaluated in earnest, but I agree with Joel that there are structural elements of spinoffs that have the potential to create outsized returns. His book cites research indicating that from 1963-1988, stocks of spinoff companies outperformed their industry peers and the S&P500 by about 10% per year in their first three years of independence.  In looking how they might have performed as a group relative to the broader index more recently, I pulled up a chart of the Guggenheim Spin-Off ETF (CSD):  Sure enough, the Spin-Off ETF handily beat the S&P 500 return over the past 7 years (about 80% gain vs. 45% for the S&P 500), although it should be noted that the superior performance of the ETF didn’t really start kicking in until 2013:

One of ATG’s holdings, White Wave Foods Company (WWAV), is a recent spinoff success story. Since parking from Dean Foods back in May of 2013, they have more than doubled their market cap through strong growth and investor appetite to pay a premium for companies that specialize in the organic food arena.

What’s the POINT of all of this. A stock pick, of course!   Stay tuned for Part II where we analyze an interesting spinoff that’s a strong contender for the portfolio.