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Take a Spin

27 January 2014 in Trading Ideas

It’s easy to understand why spinoffs capture headlines given that they often come with hopes for a prosperous, yet uncertain future, along with a sprinkle of drama that may have come from investor activists pushing management to unlock shareholder value and deliver a happy ending to the bottom line. This result forms the thesis behind our newest motif: Spinoffs.

Earlier this week, famed hedge fund investor Dan Loeb announced that his Third Point fund had just taken a position in Dow Chemical. Loeb didn’t reveal the size of the position, but he did say that it was now Third Point’s third-largest position.1

And Loeb has already made his voice heard, telling investors in a letter that Dow’s previously announced plans to exit low-margin chemical operations wasn’t exactly the rejuvenation program he’s looking for.

Instead, Loeb is calling for a more dramatic split of the units that turn oil and gas into chemicals from the unit that makes higher-margin specialty chemicals used in agriculture, food, pharmaceuticals and electronics. Loeb wants outside advisors to look at Dow’s current plan and determine whether a better route to drive shareholder value might be spinning off its petrochemical business.

spinoffsAccording to Loeb, Dow’s shares have performed woefully over the last decade, particularly when compared with the S&P Chemicals Index. Driving the dagger home, Loeb said that Dow’s underperformance was particularly surprising given that the shale gas revolution in the US has been a powerful tailwind for the company’s biggest business exposure – petrochemicals.

How did the market react to news of Loeb’s big stake? Dow’s shares rapidly shot 7% higher.

Welcome to Wall Street’s not-so-little secret: Investors often favor companies with focus. And that’s why spinoffs can offer a chance to capture some of that value that parent companies are trying to unlock.

In many cases, it’s easily seen. A recent Credit Suisse study found that over the past 17 years, spinoff companies outperform the S&P 500 by about 13% in their first year of liberation.

What’s going on? As Joe Cornell recently pointed out in Forbes, the effect of the spinoff is to allow all parts of a business to be properly valued.2 As a company is first spun off that can mean a company is orphaned at first, without a lot of analyst attention and with their stocks in the hands of index funds that are forced to sell the spinoff.

However, that kind of selling can create good opportunities in a new firm where entrepreneurial instincts have just been unleashed, Cornell says. The independence can help motivate management to operate more efficiently, while stock options and other performance vehicles may create huge incentives to deliver performance. Still, there’s no guarantee that the newly spun company will perform like anything other than a new company, complete with growing pains and without the financial backstop that it may have previously enjoyed while tucked within the business line of a parent company.

But if you do find spinoff investing an intriguing idea, the Spinoffs motif may be an alternative worth considering.

1Maureen Farrell, “Dan Loeb Takes a Stake in Dow Chemical,” WSJ.com, Jan. 21, 2014.

2Joe Cornell, “Addition by Subtraction: The Art of the Spin-off,” forbes.com, Oct. 7, 2013, http://www.forbes.com/sites/joecornell/2013/10/07/addition-by-subtraction-the-art-of-the-spin-off/, (accessed Jan. 21, 2014).

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