These Ignored Stocks Consistently Beat the Market

Ryan Fuhrmann's picture

Friday, February 18, 2011 - 1:30pm

by Ryan Fuhrmann

A profitable investment strategy is to buy into a stock with a major catalyst that can potentially take hold and send a stock price higher. That's obviously easier said than done, but many savvy investors who identify a catalyst early on can often snag the stock just before it moves and before the rest of the crowd.

Big changes at a company are a good place to look for catalysts, be it a new management team, new product or a major acquisition. One of the single best catalysts for a stock is often a spinoff. This is when a company separates, or "spins off" a division in order for it to become a publicly-trade company in its own right.

Spinoffs have a good track record of beating the market, according to the Journal of Financial Economics. There are a number of reasons for this. From the new company's perspective, new freedom often means the chance to grow market share and reduce costs without distractions from  a parent company.

Studies have shown that sales and profits can improve markedly when a spinoff company is set free, thanks in no small measure to  a new management team that is usually energized and highly motivated. A study in the Journal of Applied Finance in 2003 listed spinoffs as a proven way to increase share value as the new company can perform better once freed from the parent.

From an investor's perspective, spinoffs don't usually get a lot of attention from Wall Street. Investment banks make tons of money from initial public offerings (IPOs), but spinoffs go to existing shareholders of the parent company, though the public can participate after the shares start trading..

Also, not much financial information is available for spinoffs. When a spinoff was previously part of a larger parent company, the financials are often only skin-deep and are combined with the results of its former parent. Finally, the parent company's shareholders often just sell the small amount of shares they receive from a spinoff, as they tend to be only interested in owning the parent in the first place. (But based on the historical performance of spinoffs I mentioned earlier, that's often a mistake.)

A final important point is that spinoffs are often acquired  by a rival or a strategic buyer (such as a private equity shop) after they are separated from a parent -- usually at a hefty premium.  E-commerce firm First Data Corp., for example, was snapped up by private equity shops for about a 30% premium while financial technology firm Metavante was acquired by rival Fidelity National (NYSE: FIS) for a 23% premium after both companies were split from a former parent.

Below is an overview of three coming spinoffs where takeover potential is seen as imminent for some of the divisions. In two of the cases, the parent company plans to split into three separate companies. In the other, the parent intends to split into two. Either way, for investors, there could be something worth investigating further with these three stocks, if history is any guide. Let's take a look... 
    
1. Fortune Brands (NYSE: FO)
Businesses: Spirits, housing products, golf
P/E: 22

The motivation for Fortune Brands' existence never seemed clear given the disparate operations. The crown jewel is the spirits business, which includes the largest bourbon brand in the world, Jim Beam, as well as Maker's Mark and Effen vodka. Fortune's home division sells MasterBrand cabinets and Moen faucets, while the golf division consists of the Titleist and Footjoy brands.

Fortune's brands are leaders in their respective spaces, but the stagnant home and golf divisions have had some rough stretches and have seriously hampered the value of the spirits business.  The company made the decision to break itself up in December and said it would do so within the next couple of months.

The consensus on the Street is the spirits business will be quickly acquired by a global titan such as Diageo (NYSE: DEO) or Pernod Ricard. The home business will recover over time and could be combined with a company like Mich.-based home improvement product make Masco (NYSE: MAS) to cut costs and wait for demand to improve. Callaway Golf (NYSE: ELY) is a pure play on golf retailing that could be interested in Fortune's golf unit. In any case, each spinoff will be in a much better position to grow market share or fall into the hands of a rival, both of which could mean gains for shareholders.

2. ITT Corp (NYSE: ITT)
Businesses: Defense, industrial products, water services
P/E: 12

ITT's days as a conglomerate are numbered. In January it decided to split into three separate firms. Management's motivations speak to just why spinoffs are good investments. Namely, in the company press release announcing the break up, management detailed that "each new company will be more nimble and able to build stronger, more intimate customer relationships to accelerate mutual success."

The breakup will leave a global water technology firm that tests, treats and transports water on behalf of water municipalities and related clients. A pure play defense firm will also emerge that provides night vision and surveillance services, as will an industrial products firm that sells pumps, valves and control systems to other industrial customers.

ITT still sports a low earnings valuation that will likely carry over to each new firm after the spinoff. This will appeal to investors as well as potential acquirers, including Mueller Water Products (NYSE: MWA-B), Northrop Grumman (NYSE: NOC) and Illinois Tool Works (NYSE: ITW), which are leading firms in each of the respective industry groups where these newly independent firms will operate.

3. Sara Lee (NYSE: SLE)
Businesses: Packaged food products
P/E: 19

Sara Lee has been subject to a steady stream of buyout rumors from private equity shops and rival food firms including Apollo Management and Brazilian firm JBS. Many of the potential acquirers were kicking the tires on Sara Lee, but apparently management was looking for a price north of $20 a share for the entire company (shares currently trade near $17). With no bids in this range, it made the decision to split itself in two and plans to do so by early 2012.

The Sara Lee name will stay with the North American food and foodservice business, while a new company will be formed for the international beverage and bakery business. In management's words, "these two pure-play companies will have their own distinct growth strategies within their respective core markets that will attract a more focused shareholder base." In addition, they will be more appealing to takeover interest, with a food rival such as Kraft (NYSE: KFT) or Nestle potentially interested in the cash cow domestic business or international operations that have more growth potential.  

Action to Take ---> There are two primary strategies to pursue to take advantage of the above spinoffs or spinoffs in general.

An investor can buy into the current company and receive shares in each company once the transactions occur. This could work out well and let you get in on the ground level, capturing any run-up the first day the spinoffs start trading.

Another strategy is to wait until the spinoffs occur and invest in the businesses with the most upside potential. Fortune Brand's spirits business and ITT's defense operations look especially appealing in my mind. Of course, the shares could immediately run higher when spun off, but it would mean avoiding having to take shares in the stodgier parent businesses with less growth appeal.

A final approach is to wait and see how the new companies perform, as it will likely take time for Wall Street to warm to their prospects.

Ryan Fuhrmann does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of DEO in one or more of its “real money” portfolios.