Imagine that you own shares in a company, which is going to demerge one of its business. Once a demerger/Spinoff occurs, investors have an important decision to make: Whether to sell or hold shares of the parent company or to sell or hold shares in the new company?
Demerger or Spin-off
When a company does a demerger, a particular segment of that company’s business becomes a new company. A demerger can be seen as the opposite of a merger. In a demerger, a company distributes its entire ownership interest in a business unit as a stock dividend to existing shareholders. It is tax free and usually helps both the parent company and new company (spinoffs) achieve better results by operating as separate entities.
Stock price performances
Studies have found that shares of both the parent and the newly listed company will outperform the market with the edge going to the Spinoffs. What could be the reason behind this outperformance?
Spinoffs outperform because the management team will have greater freedom to produce, to start new ventures, and to control costs. Similarly, the management teams at parent company can focus more on their core businesses. Stock prices of both the listed entities may increase because of investors’ preference for focused and pure play companies. Thus, there is no problem in holding shares of demerged entity and parent. However, if one needs to be sold, study suggests that, because of its smaller margin of outperformance, the shares of parent company should be sold.
Still, one needs to be cautious on holding the spinoffs. With their smaller market capitalization and financial capacities, these stocks tend to be more volatile. These would be mostly high beta stocks, which are likely to underperform in weak markets and outperform in strong markets. Therefore, it is better to own spinoffs during a bull market.
Secondly, studies have found that spinoffs usually sell off in the months immediately after the restructuring. Issuing shares in a demerged entity to existing shareholders is not an efficient way to distribute stock, as a majority of the shareholders will be interested in the parent company. Index funds, which hold shares, will sell the company as the newly listed entity will not be there in the index.
Risk involved and Investment decision
One important factor to be considered is the return on capital employed. A parent or a Spinoff with a low reading may not have a good strategic advantage in its line of business.
Before taking the final decision to whether hold the shares of the parent or the new company,or both, it is important to understand the reason for such a demerger. One has to find out how the pro forma balance sheet and P&L statements of both the parent and the spinoff will look like. One important thing to look for is the debt levels and allocation of other liabilities and troubled assets. Sometimes, a parent could transfer major portion of troubled assets and debt to the new company. Investors should also focus on the quality of management and corporate governance record of the company.
“The whole secret to winning big in the stock market is not to be right all the time, but to lose the least amount possible when you’re wrong.”