What to look for in a spin-off?

By bmvtyea | Bernie-flow | 21 May 2021

In today's edition let's talk about a process that is very common in the financial markets of other countries, but little explored in Brazil, the spin-offs or spin-offs.


A spin-off is the separation of a subsidiary from its parent company by distributing shares as "dividends" to shareholders of the parent company, or, alternatively, by selling shares to the public on an IPO.


In both cases, after a spin-off, the spun-off company changes from a private company to a public company, whose shares are traded on the stock exchange.


The Brazilian stock market is still underdeveloped when compared to stock markets in other countries. To give you an idea, between 1990 and 2006, there were more than 800 spin-offs on the United States stock exchanges, which totaled more than US $ 800 billion in market value, according to the book "Structuring Mergers & Acquisitions". When we look at the Brazilian stock market, we realize that spin-offs are quite rare processes.


Many studies have investigated spin-offs and found that they and parent companies generally outperform the market, with an advantage for the spun-off company.


One of the most cited studies was published in a 1993 issue of The Journal of Financial Economics. This study found that splits and matrices outperformed the S&P 500 index by an average of, respectively, 30% and 18%, during the first three years of trading.


As a result, an important question arises, "What to watch for spin-offs?"


To answer this question, we will turn to the excellent book “You Can Be a Stock Market Genius” by Joel Greenblatt.


Joel Greenblatt teaches us something valuable by showing us how important it is to assess who the spin-off managers are and what their compensation plan is.


In many cases, senior employees of the parent company start to manage the spun-off company, whose activity is often significantly less compared to that of the parent company.


With this, the question arises: why would the CEO of a large company abandon a central role and a high salary and start running a small, anonymous company?


There is only one reason for this: he believes that he could turn this small company into a large one and, as a consequence, he would receive a notable financial reward for it.


It is important to note that the spin-off process is not easy to analyze - it usually deals with a small, unknown company with limited financial data and, therefore, the analysis of a spin-off requires not only knowledge of the financial statements, but also of dedicated area experience.


This is the reason why only a few investors look at spin-off companies that are just getting started. Investors who choose to examine spin-offs can detect this price distortion and earn big when stocks return to their fair price.

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