He is not alone. Seth Klarman of Baupost Capital and Peter Lynch of Fidelity also focused on spin-offs as a form of “special situations” investing.
Investors in special situations (typically hedge funds) look for unique opportunities to take advantage of anomalous market conditions.
Dan Loeb, founder of Third Point, recently reflected on this theme in an interview. He described how event-driven investors often find opportunity in situations where a new security was created and the natural shareholder base has not yet formed.
A spin-off can create exactly that situation.
After the Board of Directors of a public company decides to spin off a business, shareholders automatically receive shares in the new company.
Some shareholders may not understand the business. Some may not be permitted to own a smaller company. Some may sell because the position is too small to matter.
Others may sell simply because the stock showed up in their account and they do not want to do the work.
That selling pressure can temporarily depress the price of the new company. This is one reason spin-offs have historically attracted value-oriented investors.
But there is another reason. Businesses often perform better after they are separated.
Inside a large parent company, a business may be underappreciated, under-managed, or under-incentivized.
The parent company usually has higher priorities. Management teams running the smaller business unit often have limited autonomy. Capital allocation tends to be dictated by the needs of the larger enterprise.
But once the business becomes independent, the incentives change.
Management gets its own stock. The board of the new company is focused on a single business line. Capital allocation can be tailored to the company’s specific opportunities.
Whereas the business unit may have previously been a rounding error in a much larger operation, investors can now evaluate the company on its own merits. In many cases, the business becomes sharper, more focused, and more efficient.
This does not mean all spin-offs are good investments. Many are not.
Sometimes the parent company is getting rid of a weak business. Sometimes the spin-off is burdened with too much debt or other liabilities, such as lawsuits. Sometimes the business is structurally challenged or the apparent cheapness is justified.
The old mechanical strategy of buying into almost every spin-off no longer works the way it once did. Markets are more efficient. Investors are more aware of the playbook. There are many more professional investors searching for the same set-ups.
Investors in spin-offs nowadays therefore need to be more discriminant than they perhaps were in the past. Yet the right ones can still be quite attractive.
What makes this one interesting
The newly received security—which was spun off by a financial services stock that is held within the American Resilience Model Portfolio—has several characteristics we like.
The underlying business is subscription-based, with sticky recurring revenue.
It has high profit margins, serving a large addressable market with well-known brands.
It leverages hard-to-replicate proprietary data sets and has become embedded in customer workflows.
The market is just now coming to terms with this opportunity. The shares have been trading for less than two weeks.
Below, we share what we have learned about this business… and why we view it as a keeper.
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