Joel Greenblatt: Why Spinoffs Provide Attractive Returns For Shareholders

Johnny HopkinsJoel GreenblattLeave a Comment

In his book – You Can Be A Stockmarket Genius, Joel Greenblatt discussed why spinoffs provide attractive returns for shareholders. Here’s an excerpt from the book:

Another reason spinoffs do so well is that capitalism, with all its drawbacks, actually works.

When a business and its management are freed from a large corporate parent, pentup entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course.

After a spinoff, stock options, whether issued by the spinoff company or the parent, can more directly compensate the managements of each business. Both the spinoff and the parent company benefit from this reward system.

In the Penn State study, the largest stock gains for spinoff companies took place not in the first year after the spinoff but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spinoff’s stock can perform at its best. More likely, though, it’s not until the year after a spinoff that many of the entrepreneurial changes and initiatives can kick in and begin to be recognized by the marketplace.

Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spinoffs, there is more than enough time to do research and make profitable investments.

One last thought on why the spinoff process seems to yield such successful results for shareholders of the spinoff company and the parent: in most cases, if you examine the motivation behind a decision to pursue a spinoff, it boils down to a desire on the part of management and a company’s board of directors to increase shareholder value. Of course, since this is their job and primary responsibility, theoretically all management and board decisions should be based on this principle. Although that’s the way it should be, it doesn’t always work that way.

It may be human nature or the American way or the natural order of things, but most managers and boards have traditionally sought to expand their empire, domain, or sphere of influence, not contract it. Perhaps that’s why there are so many mergers and acquisitions and why so many, especially those outside of a company’s core competence, fail.

Maybe that’s why many businesses (airlines and retailers come to mind) continually expand, even when it might be better to return excess cash to shareholders. The motives for the acquisition or expansion may be confused in the first place. However, this is rarely the case with a spinoff. Assets are being shed and influence lost, all with the hope that shareholders will be better off after the separation.

It is ironic that the architects of a failed acquistion may well end up using the spinoff technique to bail themselves out. Hopefully, the choice of a spinoff is an indication that a degree of discipline and shareholder orientation has returned. In any case, a strategy of investing in the shares of a spinoff or parent company should ordinarily result in a preselected portfolio of strongly shareholder-focused companies.

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