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Spinoffs: Looking For Value

Investing in and around spinoffs has been an extremely lucrative endeavor over the past decade, according to the Nov. 30 issue of Value Investor Insight. Indeed, since the end of 2002, Bloomberg has maintained a U.S. Spin-Off Index, which tracks the share prices of newly spun-off companies with market capitalizations of more than $1 billion for three years after they begin trading. Over the near 13-year period tracked, Bloomberg’s U.S. Spin-Off Index has risen 557%, compared to a return of 137% for the S&P 500. Moreover, spinoff activity is close to an all-time high as companies, spurred on by activists, try to unlock value for shareholders by splitting up their businesses. This year’s total number of spinoffs is expected to be 49, the fourth-highest level on record. However, more often than not, due to a number of factors, spinoffs are mispriced by the market, which can lead to some very attractive opportunities for value investors. In this month’s issue of Value Investor Insight , four spinoff experts – Murray Stahl of Horizon Kinetics, Joe Cornell of Spin-Off Advisors, The London Company’s Jeff Markunas and Jim Roumell of Roumell Asset Management – discuss the key factors that lead to spinoff mispricing and where they’re looking for opportunity today. (click to enlarge) Spinoffs: Four key factors There are four key structural factors that can lead to spinoffs being mispriced : Limited information – The documentation filed with the SEC when companies split can be quite complex, and the pro-forma financials can be difficult to analyze. Moreover, analyst coverage tends to be limited, and investors, rather than do the legwork themselves, would rather look elsewhere. Forced selling – A spinoff may see a parent company force a SpinCo onto a shareholder that doesn’t want, or legally can’t hold the shares, which will lead to selling. An S&P 500 Index fund can’t own a spinoff company outside the index, for example. Sandbagging – SpinCo managements usually receive significant financial incentives to underperform and over-deliver. Top managers’ incentive stock plans are typically based on average share prices of the spinoff company for the first 20 or so days of trading after the spinoff, which can lead to sandbagging of the highest order before those prices are locked in. ” Capitalism works ” – According to Value Investors Insight , when a SpinCo leaves its parent, “pent-up entrepreneurial forces are unleashed” as “the combination of accountability, responsibility, and more direct incentives take their natural course.” In other words, without the parent, the newly independent company can take advantage of capitalist forces to improve performance. Spinoffs: Looking for value So what do the experts look for in a good spinoff? According to Murray Stahl of Horizon Kinetics, there are four key characteristics to look for when a company spins off an unwanted subsidiary or division. First, a higher-margin business is spinning off a lower-margin business. Second, CEO movements. If the CEO of the larger company decides the best place to be is with the spinoff it’s, “a message to heed.” There’s also the capital structure of the SpinCo to consider. Too much debt dumped on the SpinCo from the parent can be a burden that haunts the company and strangles growth. That said, if figures show that the debt can be paid down over time, this creates an opportunity, like a publicly-traded leveraged buyout, according to Murray Stahl. And the last spinoff situation that creates an opportunity for profit is the very small spinoff that those engaged in industrial-scale money management are unable or unwilling to own (market cap

Stay Out Of The Junkyard: Low-Priced Stocks Are Hazardous To Your (Financial) Health

My last post generated a fair amount of negative feedback on my Yahoo Finance page and on Twitter . There’s nothing quite like waking up in the morning and being called an idiot (and worse) by all sorts of strangers on the internet. I understand that people have strong feelings about Fannie Mae and Freddie Mac, but I have to say, the vitriol of the comments took me by surprise. Setting aside whether it was fair (or legal) for the government to change the bailout terms for Fannie and Freddie, my main point in writing about the two giant GSEs seemed rather straightforward: the low-priced stocks and preferred shares of Fannie Mae and Freddie Mac are extremely risky investments. If Washington formally nationalizes these companies (or does so informally, as it seems to be doing right now), there is a good chance that their stocks will go to zero. Sure, the big hedge funds and their armadas of lawyers might prevail in court and win the return of the companies’ dividends to shareholders. But even if that happens, it will probably take years. As I wrote in the last line of the post, “There are easier ways to make money.” The broader lesson of the GSEs for both retail and professional investors can be stated in four words: What do I mean by junk stocks? There are all sorts of ways to answer that question. Usually, junk stocks are defined as companies with shrinking revenues, outsized debt loads and negative cash flows. But there’s an easy way to spot junk stocks without digging through financial disclosures: if a stock is below five bucks, it is more than likely a troubled mess not worth investing in. As I write in my book Dead Companies Walking , the vast majority of low-single digit stocks in the market are over – not under- priced. Almost all of them have been relegated to the stock market pick-n-pull for one (or more) of three reasons: a bad business, a bad management team, or a bad balance sheet. It’s not uncommon for companies with sub-$5 stock prices to suffer from all three of these maladies. Yet, many investors cannot resist the temptation to buy these jalopies, hoping for a turnaround that almost never happens. Like vintage cars, a small percentage of cast-off stocks do defy the (very long) odds and regain their former glory. But here’s the thing pick-n-pull investors fail to understand: those stocks are even better buys at $8 or $10 than they were at $2 or $4. Why? Because improving fundamentals have taken hold by then, and the wider market has taken notice. Good news spreads quickly, and healthy, wealthy, and popular companies tend to get healthier, wealthier, and more popular as cash flows fatten and more investors pile in. Consider how brutally top-heavy the markets have been this year. At the end of July, I (lightly) cautioned investors to be wary of the high-flying FANG quartet – Facebook (NASDAQ: FB ), Amazon (NASDAQ: AMZN ), Netflix (NASDAQ: NFLX ), and Google ( GOOG , GOOGL ) – saying that any correction in the tech sector could also drag these stocks down to earth again. So much for market forecasting. Shortly after I wrote that post, the market did go through a correction. The FANGs fell along with everyone else, but they’ve all charged to new highs since then. If you add the other two largest tech companies (Microsoft (NASDAQ: MSFT ) and Apple (NASDAQ: AAPL )) to the FANGs, these six behemoths now comprise 12 percent of the S&P 500’s $18.5 trillion total market capitalization, and have accounted for just about all of the index’s gains this year. If these half dozen names were flat, not up, the S&P would be down 1.5 percent year to date instead of up 1 percent. More importantly from an investment standpoint, the likelihood that any of them will go broke is exactly nil. They all have rapid revenue growth, strong balance sheets, capable Boards and highly educated employees. Those attributes are much harder to find at troubled companies with sub-$5 stock prices. The top-heaviness of the current market might be extreme, but it isn’t new. Historically, a minority of stocks have always outperformed the overall market over any lengthy time period. All the major indexes (minus the Dow) are market capitalization weighted. That means a few mega-cap winners, like Google or Amazon, can (and often do) offset the stock price declines at dozens, or even hundreds, of smaller companies. Though I usually don’t buy the stocks of large, widely analyzed businesses, my own returns as a fund manager bear this out. My best performance has occurred when most of my shorts are below $10 (and hopefully heading toward zero) and my longs are pricier. In years where junk outperforms value (like 2003 and 2009), I tend to underperform. A few years back, Blackstar Funds analyzed the returns of the Russell 3000 between 1983 and 2007. Even for a cynic like me, the bearish results were shocking. Of the 8000+ stocks that were either in the Russell 3000 originally or that entered it at some point during the study period (usually via an IPO), 39 percent produced a negative lifetime total return – with 19 percent losing over 75 percent. Only 1 in 5 stocks produced a 300 percent or greater return. And yet, over that same time period, the Russell 3000 gained over 1000 percent – all because a small handful of large winners crushed the median stock’s advance. In life and in the stock market, the rich tend to get richer. For everyone else, it’s a different story. Original Post

Historical Rates Impact Common Stocks

Summary We think there is a recency bias surrounding interest rates. Historical rates are in the band between 3% and 6%. We believe rates will rise when there is a demand for credit, which can be a good thing for common stock owners. Time and coincidence often cloud our own perception. Consider interest rates. Baby Boomers and Generation Xers became adults (25 or older) between 1965 and 2005. During that period, these adults witnessed an aberration in the history of interest rates. They saw moments of monumental highs (20%) and levels consistently above historical norms. The chart below shows that long- and short-term interest rates in the United States have spent most of the last 400 years in a range between 3% and 6%. We contend that this deviation clouds the judgment and expectations of many of today’s investors. There are numerous implications for long-duration common stock owners arising from the examination of historical interest rates. Intrinsic Value Computations The father of value investing, Ben Graham, concluded through his years of research that 10-year corporate bonds averaged 4.4%. Therefore, in his revised intrinsic value equation, he used 4.4% as the numerator for adjusting intrinsic value based on interest rate fluctuations. This long-term interest rate chart supports the validity of his choice, and is right in the middle of the 3-6% historical range. One could argue that long-duration equity investors have been using discount rates in their intrinsic value calculations much higher than historical interest rates justify. This is likely due to the unusually high rates of the period between 1965 and 2005, a recency bias. Commitment of Capital to Bond Investments In 1980, the prime interest rate at the major banks was 20%. Long-term Treasuries peaked at 15% in early 1981. Inflation topped out in 1981 at 11%. Thirty-year fixed mortgages were issued as high as 17%. What people didn’t realize at the time was that they were living through a five-standard deviation event, according to history. Even if inflation had stayed at 11%, those interest rates offered investors very high inflation-adjusted returns. As the famous bond investor Bill Gross has argued, this laid the groundwork for more than 30 years of declining interest rates and a normalization back into the band between 3% and 6%. This has rewarded bond investors and got them addicted to an asset-allocation commitment based on lookback returns which are statistically unlikely. Interest rates are currently below the historical 3-6% range, and will likely rebound over the next 10 years into the historically normal band. We believe common stock buyers should include that likelihood in their stock selection methodology, whether in their intrinsic value calculations or in the effect that higher rates in the U.S. have on the U.S. dollar and overall economic growth in the country. We contend that the surprise in the U.S. will be how much stronger economic growth will be than what is expected. How else can rates go up, unless someone demands the capital via borrowing? Need for Solid Returns for Investors Owners of wealth in the form of liquid assets have an economic need in both low and high interest rate time periods. They need to earn a return above inflation to defend the purchasing power of their liquid asset pool. Ownership of long-duration common stocks has proven to be superior to that of other liquid assets over long time periods, except for the 10-year stretch from 1999 to 2008. As 10-year Treasuries fell to 1.6% in 2008 and stocks were liquidated in the financial crisis, two five-standard deviation events conspired to elevate bond investments in popularity and thrust bond portfolio managers into god-like status. We think a good rule of thumb is to avoid portfolio success stories created by five-standard deviation events. These only happen 2.5% of the time. Rather than being preoccupied with the consensus of investors, we believe building our portfolio around high-probability events is much more valuable to the long-term investor. Industries Benefited By Higher Rates in the 3-6% Range We have argued ad nauseam that common stock investors have two possibilities in front of them as it pertains to interest rates. If interest rates were to rise back into the 3-6% historically normal band, there must be forces which demand the money and industries which benefit from the forces that cause the rise in rates. If rates stay below the historical band, intrinsic value calculations using discount rates above the historical average will undervalue common stocks. Certain industries would welcome higher interest rates. Insurers must earn interest on collected premiums, banks would like to charge more for loans, and homebuilders would like to have so many customers for new homes that the resulting demand for money drives up interest rates. Consumer discretionary companies would love to see a level of prosperity which would drive retail sales and liberal advertising budgets. Drug and biotech companies would like everyone to be able to afford the fantastic new medicines they will introduce in the next 10 years. In summary, above-average returns don’t come along without taking risk. Investors have become very comfortable with today’s historically low interest rates, and fear continued poor economic growth rates. Equity portfolio managers use discount rates higher than today’s actual rates because of the abnormally high rates of the last 40 years. Lastly, the contrary long-duration common stock investor should be attracted to industries which benefit from the gravitation back into the historically normal returns from the bond market. The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past 12-month period is available upon request.