Scoop Up Gains from Spin-Offs

04/23/2015 9:00 am EST

Focus: ETFs

Tyler Laundon

Editor, Cabot Small-Cap Confidential

The spin-off is back in vogue. And returns for many spun-out companies are trouncing the broad market, explains Tyler Laundon, editor of Game Changers.

Last year, 60 US spinoffs were completed. That made 2014 the biggest year for spin-offs since 1999 and 2000, when an astounding 66 were completed in each year.

Some may interpret the spin-off trend as a sign that capital markets are becoming frothy, with too much excess capital sloshing about. And some may interpret it as a signal that the era of the conglomerate is officially dead.

Regardless of interpretation, one thing is crystal clear—spin-offs are on the rise—and investors are more than happy to snap up shares of companies with more of a pure-play focus.

In layman's terms, the mechanics of a spin-off are simple. A parent company distributes all of its ownership interest in a subsidiary business via a dividend to existing shareholders. Once the spin-off is complete, there are two distinct, publicly traded companies with the same shareholder base.

Skeptics will say that the primary beneficiaries are the Wall Street M&A advisers who collect fat fees when a company embarks on a major restructuring. But in truth, the reasons can be far more investor-friendly, such as unlocking dormant value in a business unit that can go forth and flourish on its own.

From a capital perspective, a pure-play can establish a capital structure that is appropriate for its line of business. And from a financing perspective, a pure-play can better use its stock as currency to fund future acquisitions.

One simple way to play the trend with a single security is with an ETF designed around the event. The Guggenheim Spin-Off ETF (CSD) is rebalanced semiannually and only includes companies that were spun-off six to 30 months prior to the rebalance date.

The performance of this ETF has been exemplary. Over the last five-year, three-year, and two-year periods, it has risen by 138%, 94%, and 41%, respectively.

The ETF's returns over all of these periods outpaced the S&P 500, which rose by 76%, 55%, and 33%, respectively, over the comparable periods. Year-to-date, the Guggenheim Spin-Off ETF is leading again, rising by 9.3% versus 2.3% for the S&P 500.

I don't think the spin-off trend will abate in 2015. Already, more than 45 companies have announced plans to complete spin-offs. And it's easily possible that 50 or more will be completed before year's end.  

That should give us a robust pipeline of new pure-play companies to evaluate in the coming months. While not all will be good investments, I expect that investors, who are early to buy into healthy and growing spun-out companies, will be well positioned to profit over the coming years.

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