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Lessons Learned Investing in MicroCap Spinoffs

In a spinoff, securities of some company shows up in your brokerage account.  You didn't ask for it, you didn't buy it, and you may know very little about it.

What do the following four MicroCapClub stocks have in common?  Atlas Financial Holdings (AFH which I own) insures taxi-cab drivers, Nova Copper (NCQ) is developing a copper mine in Alaska, Parametric Sound (PAMT) makes and licenses out-of-this-world directional sound speakers, and Straight Path Communications (STRP) sues big tech companies for infringing their patents.  What’s the common link?  They’re all recent spinoffs.

Some investors specialize in technology stocks, others in the resource industry or financial services.  I specialize in special situations.  Spinoffs, rights offerings, divestitures, restructurings bankruptcy emergence, regardless of the industry, I’m interested.  But spinoffs are where I’ve made the most money.  Famous and accomplished value investors like Seth Klarman, Joel Greenblatt, Charlie Munger, and even Cramer cite spinoffs as a favorite source of ideas.  From the recommendations above, MicroCapClub members apparently have an interest in spinoffs too.  Much has been written on the topic before, but the notable and popular book is Joel Greenblatt’s “You Can Be a Stock Market Genius”.  After 15 years of buying spinoffs I’ve found the advice in this book to be so spot-on that there is only a little to add related specifically to the microcap space.  So let me begin by summarizing the reasons Mr. Greenblatt cites for the academically verified spinoff outperformance.

  1.  Indiscriminate selling.  In a spinoff, securities of some company shows up in your brokerage account.  You didn’t ask for it, you didn’t buy it, and you may know very little about it.  Perhaps you’re an Index Fund and you’re only allowed to own stocks in the S&P 500.  Perhaps you’re  a mid-cap mutual fund and you’re not allowed to own microcaps.  Perhaps your fund specializes in financials and the spinoff is the banking software business that you’re not interested in.  In the case of microcap spinoffs, it’s often the case the dollar value of the spinoff shares is a small fraction of the value of your investment in the parent.  You’re not going to investigate what the spinoff is worth, you’re just going to sell.  Perhaps a majority of the shareholders of the new spinoff are in similar situations.  Lots and lots of selling and all at the same time and nobody cares much what price they get.
  2. Lack of information about the spinoff.  If you ever look at say Yahoo Finance for the Key Statistics for a recent spinoffs the numbers will be “wrong”.  They and every other reporting service will have the companies historical financial numbers not the Pro-Forma.  Furthermore, especially in the case of micro-cap spinoffs, there will be no analyst coverage.  There won’t be an investment banker touting the new issue with an IPO roadshow.  The spinoff company’s communications are often, in fact, dead quiet as the stock begins to trade with little or no investor presentation or spinoff conference call.  Mr. Greenblatt notes that management stock options are often priced based on the first day or first week of trading.  Management wants a low initial stock price.  You’re a technical analysis guy that doesn’t care about fundamentals anyway?  There’s no historical chart to read.
  3. Release of small company entrepreneurial spirit.  An often-cited reason for spinning off little companies is to tie executive incentive options to the performance of the spun-off division.  I’m a corporate employee of a Dow Jones member company that receives restricted stock as partial compensation. While I have a big impact on the performance of my division, I have so little impact on my company’s stock price that stock ownership provides no incentive at all to me.  By freeing little divisions from their large corporate bureaucracies, an incentivized and entrepreneurial management team can often dramatically improve financial performance.

 

I’ll add one more reason for spinoff outperformance, perhaps relevant only to microcap spins, later.  But first, let me share some advice on microcap spin-off investing from my own 15 years of experience.  Most of this advice is also in Mr. Greenblatt’s book but I’ve added some small stuff of my own.

1. You should thoroughly read the Form 10 filing from the first page to the last and read between the lines.  Well, of course, you say but the fact is lots of people make investment decisions without reading the SEC filings.  Furthermore, spinoff investing can be a game of hide and seek.  It’s often true that spinoff insiders don’t want you to understand anything until after their option prices are struck.  But the SEC requires fairly elaborate disclosure in the Form 10 filing and there’s often important information hidden in there that helps you to understand the company’s prospects.

The clearest example of this came as I was evaluating the spinoff of Cavco Industries (CVCO) from Centex Corporation in 2003.  Centex is a large homebuilder and Cavco was their very small manufactured homes division.  S&P 500 member Centex would issue one share of microcap Cavco for every 20 shares of Centex owned.  “Honey, it’s a 1 for 20, a 1 for 20 for heaven’s sake” I said to my wife as she was cooking dinner. I was so excited I could pop.  These are the best spinoffs; when the dollar value spun is a small fraction of the parent’s value there will be crazy indiscriminate selling.  And fortunately the manufactured housing industry was in the crapper.  I had owned Green Tree Financial when it was purchased by Conseco in the late 1990’s and received Conseco stock in the merger. A year or two later Conseco stock plunged and the company began a shocking downward spiral to bankruptcy.  Green Tree and then Conseco had been financing manufactured housing the way Fannie Mae would later finance stick-built homes preceding the events of 2008.  Now that Conseco was out of the business, no one would finance a manufactured home.  A mortgage is rather important to most home-buyers, so manufactured housing Industry sales were falling like a rock.  But Cavco’s sales were rising modestly;  they were taking market share like crazy.  This was a good company but in a very bad environment.  Was Centex spinning off their loser in a loser industry to avoid losses on their income statement as the manufactured housing industry evaporated?  Cavco wasn’t talking, no conference call, no investor presentation. But on page 38 of the form 10 was the answer.

The Company performed its annual goodwill impairment analysis as of March 31, 2003. This analysis used a discounted cash flow methodology with respect to the anticipated future cash flows of the manufacturing operations, and resulted in the conclusion that there was no indication that goodwill was impaired.

      To further validate its analysis, the Company engaged an independent valuation firm to issue an opinion on the fair value of the manufacturing reporting unit as of April 1, 2003. The valuation firm utilized both discounted cash flow and market comparable analyses to determine fair value. … Using results from each of these valuation approaches (with significantly more emphasis placed on the discounted cash flow approach), the valuation firm concluded that there was no indication that goodwill was impaired.

So there you have it.  The company believes there’s no goodwill impairment and an investment banker agrees.  This was really important to me as the book value of the company was over $30 a share, much of it goodwill.  Both the company’s own projections and an independent investment banker thinks the stock is worth at least $30.  I was heavily buying shares at $18.50.  As I recall the stock actually started trading around $23, but I applied the two week rule that I still abide by to this day.  If you really, really want the spinoff, you can buy after it’s traded for two weeks. Often times you want to wait longer, but you have to wait at least two weeks.  Spinoffs almost always go down in the first two weeks of trading no matter how ridiculously undervalued they might be.  I wanted this one so I bought a full position on the 10th day of trading.  It turned out this time that one of my Cavco trades was at the all time low for the stock, $18.06 I think I recall.  The stock price went up from there although it took some time before it even reached book value.

Screen shot 2013-10-23 at 2.49.36 PM

Of course this one turned out well with the company growing like a weed while the rest of the industry continued to decline.  The stock split three for two and I sold out at $45 in 2006 for nearly a four banger in three years.  As I write, Cavco is trading at $58 so an investor would have made 5 times their money in 10 years if they still held from the spinoff.

In a spinoff, like most other special situations, there’s lots of uncertainty.  There’s no analyst report, there’s no chart, and often times no investor presentation or conference call.  The spinoff company management may not want to tell you anything until options are struck.  You have to figure it all out yourself.  The company does have to file a form 10, however, and there’s often information buried in there that explains what management is thinking.  In Cavco’s case, the industry was crashing and there was no insider buying.  The only indication that company management was bullish was in the goodwill impairment evaluation on page 38.

2.  Favor the apparent garbage.  Yeah, that’s right.  Joel Greenblatt tells you the same thing in his book and my experience confirms his advice.  The best spinoff deals arise from businesses that appear undesirable.  Cavco was in an industry that was reeling and continued to reel for years afterward and is only now even beginning to show weak signs of a turnaround. They had just shut down their retail operations taking impairment charges so the historical financials didn’t look so good.  Of course, those retail businesses were gone and the remaining manufacturing businesses were taking market share … but I’ve already written articles on dispositions.

Another spinoff situation where a relatively unattractive looking businesses was distributed to shareholders was the 2002 spinoff of EnPro Industries (NPO) from Goodrich.  You older folks know the Goodrich name from Goodrich tires back in the 1980’s.  They long ago dumped all their industrial businesses, however, and were purely a very successful aerospace company in the late 1990’s.  They acquired another primarily aerospace company that also owned an industrial seals and bearings business around 1999.  Successful aerospace operations can be really terrific businesses and Goodrich stock had gone straight up for years.  This continued after the spinoff, too, until just recently Goodrich was sold out for a small fortune. But back to the spinoff situation.  Goodrich shareholders would have 1 share of EnPro, their seals and bearings business, dumped into their account for every 5 shares of Goodrich.  That’s an attractive ratio but it was really much better than that.  EnPro started trading a little above $9 while the parent’s stock price was way higher.  It’s the percentage dollar value of the spinoff that determines the extent of indiscriminate selling and this was a real attractive one.

Screen shot 2013-10-23 at 2.52.00 PM

The EnPro industrial business wasn’t near as good as the Goodrich parent, but it too was successful.  Fortunately for me, the moderately high quality of the business was disguised somewhat by the 2001-2002 recession and they had another scary problem too that kept superficial investors from buying, asbestos liability.  Bearings and seals sound boring but EnPro had high market share in higher margin self-lubricating, non-rolling, metal polymer bearings with strong brand names and worldwide distribution.  Worldwide distribution is important for quick repair of expensive equipment so OEM’s will pay a little more.  In fact, EnPro had earned $28.4 million on $533 million in revenue in the nine months ended September 30, 2001.  That’s a $1.40 a share in 9 months on a $9 stock.  And 2001 was a recession!  If you look at calendar year 2000 numbers you’d see right there in the form 10 filing pro-forma sales of $753 million and earnings per share of $2.73.  But scaring away investors was massive asbestos liability.  Now probably when a small dollar value of a spinoff is dumped into your account you just sell without looking.   But if you did take a quick look at EnPro you’d immediately see “Asbestos liability” and then you’d dump.   And a possible motivation for the spinoff is the dumping of asbestos liability off Goodrich’s balance sheet.  Frankly, this scared me too.  But when I looked deeper, I saw that the company was fully insured for their asbestos liability with some additional insurance capacity if the estimated dollar volume went higher.  I was bouncing up and down excited about this one although still wary of the asbestos liability. I watched the stock drop as I waited my required two weeks and then bought in the high $7’s congratulating myself on what a genius I was for waiting two weeks.  And the stock continued straight down to the $1’s. No kidding, this stock that earned $2.73 the prior year was trading in the $1 area.   That asbestos liability must be a problem after all and I was just an idiot.  I did, in fact, prove that I was an idiot when I ignored insider buying in the $1’s.  Isn’t this confirmation that the spinoff didn’t happen to dump asbestos liability?  And isn’t then a stock trading for less than their single year earnings the buy of a lifetime? I was shell-shocked from watching my $7 purchase go to $1 and did nothing. I sold out slightly more than three years later at $30.  I quadrupled my money, but if I had the sense to buy when the insiders did I would have made more than twenty times.  Today NPO trades at $61.

So there are some lessons here.  First, you can really get seriously low prices when the spinoff dollar value is a small fraction of the parent’s value.  Second, when the spinoff is at first blush unattractive, the mispricing is even more extreme.  Third, you should follow the insiders.  I believe insider buying is much more important in special situations than just an ordinary insider buy.  There’s some crazy change of some kind in a special situation and the insiders understand the motivations behind these changes better than you.  Double weight insider buying in microcap special situations as there is often little or no communication from management about what’s going on.

Now it’s often the case that stocks are grossly mispriced and insiders do nothing.  They stand to get rich from options after all anyway.  So Mr. Greenblatt would advise that you carefully read the management incentives package right there in the form 10 when you evaluate a spinoff.  If that package is generous with a modest cash salary, you may already have your message from the insiders. So while you’re reading that form 10 thoroughly, including reading between the lines, pay special attention to the management compensation section.  I would simply add that Mr. Greenblatt is a very wise fellow.

3.  You should look at the parent too.  I won’t elaborate with a historical example on this one but the smaller of the two new entities is the one most likely to be mispriced.  Investors own a company for the dominant business and many didn’t really want the smaller one.  You can see on the list of upcoming spinoffs (http://www.stockspinoffs.com/upcoming-spinoffs) that  United Online (UNTD) is spinning off FTD, the online flower delivery business, at the end of this month.  FTD is a very high quality business representing perhaps 80% of the value of United Online.  The remaining businesses staying with the parent include Classmates.com, and some dial-up internet service providers.  I would spend my time looking at the remaining United Online stock.  It’s going to be the one dumped as its both smaller and lower quality.  I’ve also had success buying the parent when the spinoff is announced.  It’s often a year before the spinoff happens but I’ve found that when the stock pops a little on the spinoff announcement it often runs up until the spin.

4.  Find the reason for microcap spins.  Spinning off a business costs significant money.  That form 10 has to be written by an expensive investment banker and submitted to the SEC.  Then the SEC’s questions have to be answered to their satisfaction, and finally the spinoff shares distributed to shareholders.  This can run into the millions of dollars.  When a $5 billion dollar company spins off a $1 billion company the cost is relatively small.  But there’s generally a compelling reason to spin off a microcap and an especially strong reason to spin a nanocap.  Shareholders generally are not pleased to have investment banking expenses eating into earnings so that little dinky securities they don’t want can be dumped into their accounts. Management doesn’t do these little spins for kicks.  In fact, I propose that one more reason microcap spins outperform is that there is often some compelling value-creating reason to do them in the first place.

Now there are all kinds of reasons to spin off a little company.  Leucadia National (LUK) recently spun off microcap Crimson Wine Group (CWGL).  Leucadia was a big operation selling itself and the buyer didn’t want a vineyard so they spun it first.  You’ll often see big mergers happen and the government finds the combined operation will have no competition in some area of business.  A sale or spinoff is mandated for some small part prior to the merger.  You should be interested in such a spin as they have limited competition right?  Another reason to spin that you should get excited about is that the spinoff was creating conflicts of interest or competitive problems with the parent.  A new technology or software was developed that should serve the entire industry.  But other industry participants aren’t going to buy it from their enemy so spin it off so it can sell to its old parent and everyone else too.  The SEC requires disclosure of the reasons for the spin in the form 10 filing so read it.  There’s usually some truth to the reasons cited but almost all spins cite the generic three or four reasons; to incentive separate managements, to eliminate competition for capital between the two businesses (what a silly reason), to allow investors to buy businesses with the characteristics they want, to permit acquisitions by issuing stock of an entity in the same industry as the target companies.  Beware of one reason they don’t include, to eliminate debt from the parent by dumping it on the spinoff.  It’s illegal to spin an insolvent company but sometimes a lot of debt is dumped and they do go down.  Recent Sears (SHLD) spinoff Orchard Supply Hardware just filed for bankruptcy. Because the same reasons are so often cited and so many different reasons are cited you can’t always tell which one is the real reason.  But figure it out because if you can’t immediately see the reason there may be an underlying reason that leads to a multi-bagger.  Keep in mind that employees act in their own best interests not necessarily in the best interests of the corporation.  Is the CEO of the bigger parent joining the small spin-off?  Is the stock option package for the spinoff significantly different than the parent?

MicroCapClub stock Parametric Sound (PAMT) was spun from LRAD Corporation (LRAD) in 2010.  LRAD’s prior attempts to commercialize their directional sound technology had been a miserable failure.  While the sound was mesmerizing the speakers were too expensive and too unreliable.  But big improvements had been made and the fact that the board of directors were willing to go to the expense and trouble of spinning off Parametric Sound was evidence they believed there was something to it.  I spent hours investigating this stock right after the spin but ultimately decided it was too speculative.  The CEO at the time was an engineer and a brilliant one but I worried about business skills.  Insiders started buying shares on the open market so now there were two strong signals there was something good here.  But I never bought any and today it’s up about 7 times from the spinoff price.  There’s a reason for microcap spinoffs.  Find it.  And when insiders buy, pay attention.

So to summarize advice to spinoff investors.  Get excited when the spinoff dollar volume is a small fraction of the parent.  Pay special attention when a superficially unattractive business is spun off as it’s likely to become grossly mispriced.  Dig to find value in that unattractive business keeping in mind that spinning a microcap is expensive and there must be a reason.  Realize that a microcap management often doesn’t want to communicate with investors initially so work hard on that form 10 and any other information you can get to gain understanding.  Follow the insiders as they have an understanding of what is happening in a complicated and limited-information situation.  Watch open-market buys but also consider their options packages.  Consider that the parent may be the better buy especially if its smaller and uglier.  You might buy both the parent and the spinoff on announcement of the spinoff as the two are often worth more than the one.  Finally, don’t assume you’re missing something when the spinoff price gets absolutely silly; it’s just what microcap spinoffs do.

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