Four Reasons to Consider Investing in Spinoffs

Since online travel giant Expedia spun off TripAdvisor (symbol TRIP) two years ago, TripAdvisor’s stock has soared about 170%. With TRIP’s shares selling at 33 times estimated earnings for the next 12 months, I don’t know that you’d want to buy them now. But TripAdvisor’s success is hardly unique. Spinoffs often turn out to be superb investments.

Here are four reasons to consider spinoffs, plus an exchange-traded fund that invests in them.

Returns have been high. CreditSuisse tracked spinoffs from the start of 1995 through July 2012. The results: Spinoffs beat Standard & Poor’s 500-stock index by an average of 13 percentage points per year. Other studies over different time periods have produced similar results.

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The spinoffs CreditSuisse studied didn’t excel immediately. The firm found that the typical spinoff actually trailed the S&P 500 over its first 27 trading days as a separate company. Other research has arrived at much the same conclusion.

Why? Spinoffs usually go on sale shortly after achieving their independence. . When a big company spins off a smaller company, all of a sudden the manager of a large-company stock fund owns a company that doesn't fit the fund’s investment mandate. Put in that position, most managers — indeed, institutional investors of all stripes — sell the spinoff. It often takes awhile before spinoffs find eager buyers.

A key reason spinoffs tend to do well is that the managers of these companies are more focused on success. When a company is merely a division of a much larger company, it can get lost in the bureaucracy. What’s more, executives of spinoffs often receive stock options that align their interests with those of shareholders. Previously, managers were likely to get stock options in the parent company.

Stock analysts often don’t focus on a spinoff right away. But over time, it’s easier to analyze a simpler business than a complex one, such as the parent company prior to the spinoff. Simpler businesses tend to trade at higher price-earnings ratios than complex ones. That’s another reason spinoffs tend to rise in price.

You can identify individual spinoffs by searching the Securities and Exchange Commission’s Web site. But you can also invest in an exchange-traded fund called Guggenheim Spin-Off ETF (CSD). It’s not a bad choice.

The Guggenheim ETF has returned an annualized 7.5% since its launch in late 2006. That’s nearly twice the return of the S&P 500 over the same period. What’s more, the ETF has beaten the S&P every year except 2008. In every other year except 2010, it has also ranked in the top 10% among all funds that invest in midsize companies with a blend of growth and value attributes.

Unfortunately, the ETF’s results in 2008 were far worse than a minor blemish. That year, the fund plunged 55.2%, which was 17 percentage points worse than the S&P. Although I like to think that 2008 was a once-in-a-generation event, you still have to ask yourself whether you’d have the nerve required to hold this ETF the next time we have a major bear market.

Another minus is the ETF’s price. It costs 0.65% annually — high for an ETF that tracks an index.

One reason for the high expense ratio is that the index this ETF tracks contains an element of stock picking. The ETF tracks a Beacon Trust index made up of as many as 40 spinoffs that are at least six months old and no more than two years old. The stocks are weighted by market value (share price times number of shares outstanding), with a 4.5% maximum initial weighting for the biggest spinoffs. All U.S.-listed spinoffs, including American depositary receipts of foreign firms, are eligible for the index, which is reconstituted every six months.

When more than 40 spinoffs that meet the basic criteria exist at a given time, Beacon uses a “quite complex” quantitative model to pick the best 40 spinoffs, says Julie Morris, who heads the Beacon index group. But since 2007, there have never been more than 40 spinoffs that were between six months and two years old — so they’re all included in the index.

Unless there are at least 22 spinoffs — the minimum needed to cap each spinoff at about 4.5% of the index — the index remains the same for another six months. That occurred for two years from June 2010 to June 2012. But the absence of change in the index didn’t hurt returns.

Bottom line: Spinoffs are one of those niches that seem to work but that few investors pay attention to. I wouldn’t go overboard with this ETF because of its 2008 implosion and because it features a narrow slice of the stock market. But for a relatively small percentage of your higher-risk investments, the ETF is appealing.

Steve Goldberg is an investment adviser in the Washington, D.C., area.