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Practical Investing

My Portfolio's Uninvited Guests

A well-considered spin-off can increase the value of both parent and child by allowing each to focus on a narrower set of goals.

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I never actually bought shares of Colony Starwood Homes (symbol SFR) and Knowles Corp. (KN), two stocks in the Practical Investing portfolio. That’s because they are spin-offs. Dover Corp. (DOV), which I no longer own, jettisoned Knowles in early 2014. Weeks earlier, Starwood Property Trust (STWD), which I still hold, unloaded Starwood Waypoint Residential Trust, which merged with Colony American Homes in early 2016 to create Colony Starwood.

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Spin-offs are not free money. The assets, debts and even the staff of a spun-off firm are derived from its parent company. And the value of the spinner is diminished by the assets it spun off. However, a well-considered spin-off can increase the value of both parent and child by allowing each to focus on a narrower set of goals. “Some companies are undermanaged when they are under the umbrella of a big company,” says Joe Cornell, head of Spin-Off Research, in Chicago. “There is a different dynamic when you break off; it revs up the entrepreneurial zeal.”

Because Knowles and Colony combined account for less than 2% of my portfolio, I never researched them as thoroughly as I would a stock I was thinking of buying. Most of my other holdings are far larger and thus demanded more attention.

But after long neglecting my spin-offs, I decided it was high time to take a closer look. Knowles is, by far, the smallest position in the portfolio. At a bit less than $15 per share, my 83 shares are worth $1,240. However, the company is involved in a business that seems to have ex­citing growth potential. In addition to making hearing aids, Knowles supplies the microphones and audio equipment for cell phones and the growing number of other internet-connected devices that respond to voice commands.

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But Knowles’s fortunes are closely tied to orders from its two biggest customers—Apple (AAPL) and Samsung. As a result, Knowles’s results have been spotty. For example, although the company reported operating income of 37 cents per share in the third quarter of 2016, the bottom line showed a loss of 8 cents a share because of several onetime costs.

Knowles’s CEO recently told analysts that the company is making inroads with Chinese makers of wireless phones and that he sees rising demand for better audio products because of the growth of the “internet of things”—devices that can be controlled remotely via the web. These developments should benefit Knowles over the long haul and may make earnings a bit more predictable in coming years. For now, I’m content to keep this little gamble in the portfolio but not to expand my position.

Focusing on homes. Starwood Property Trust, the nation’s largest real estate investment trust specializing in commercial mortgages, spun off what’s now Colony Starwood as a way to dispose of a smaller business that owned single-family homes and delinquent residential loans. Opportunities to cash in on troubled mortgages were plentiful during and after the financial crisis. But much of the easy money has been made, and Colony in August sold a portfolio of 1,675 loans, substantially completing its exit from the business. It used the proceeds to pay down debt and buy more homes to renovate and rent.

At $29, Colony trades at 18 times estimated 2016 funds from operations, the REIT sector’s preferred measure of profits (FFO essentially adds back depreciation to earnings). That’s in line with the average property-owning REIT, though most REITs look expensive in comparison with their historical valuations. But analysts expect Colony’s FFO to climb by 17% in 2017, and the stock yields a decent 3.0%. In sum, I think the stock is too pricey to add to my modest 115-share position (worth $3,336), but the dividend and the prospect of better growth in 2017 are sufficient reasons to justify hanging on.

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