A Diversified Spinoff Strategy

I received interesting feedback regarding my two detailed offerings regarding recent corporate spinoffs (“Aristotle Did Not Anticipate Spinoffs” and ‘New’ is the Kay at Newcastle). A number of folks were excited about the prospect of participating in the CST Brands (CST) growth story and/or the growth with income story at New Residential (NRZ).

However, there will always be a large segment of investors who enjoy reading the “story” related to a particular company, but prefer a lower risk way of implementing the related strategy. Such investors are not comfortable with the risk and volatility involved with just one or two securities, but they are willing to venture into a more diversified approach. It is to those folks to whom this posting is directed.

If you read (or re-read) my two prior pieces on spinoffs, I would be surprised if you are not struck by the considerable and significant empirical evidence I reported regarding the outperformance of spinoff companies vis-à-vis their peers and the S&P 500 Index (following the actual spinoff date). A 1993 Penn State University study determined that the spinoffs it studied outperformed the S&P by approximately 10% per year post-spinoff (for the first three years). Six years later, a McKinsey study of almost 170 restructurings amplified the earlier data – showing that spinoffs provided a two year annualized return of 27%, while the S&P and Russell 2000 underperformed during that period (17% and 14% respectively).

A natural follow-up question is: “How do I take advantage of such outperformance without assuming undue risk?”  You’ll be pleased to know that I have a simple, straightforward answer for you!

In 2006, Guggenheim Investments took the Beacon Spin-off Index and created an ETF.  The Beacon Spin-Off Index itself is comprised of U.S.-traded securities – including stocks, ADRs (security of a foreign company that can be traded on U.S.exchanges), and MLPs— each of which has been spun off within the prior 30 months, but not more recently than six months prior. The indexers then rank the securities that qualify under the above spinoff criteria – measuring each on the basis of a number of quantitative factors, meant to reveal the strongest companies relative to growth and potential success.  Once the ranking is completed, the top forty candidates are identified.

The ETF built to mirror this Beacon index is (not surprisingly) called the Guggenheim Spin-Off ETF (CSD).  The CSD portfolio managers draw from the list of the top forty spinoffs, assigning a modified market cap weighting to each issue (maximum of 5%). As you’ll see later, the relative weighting of each stock in the ETF will constantly change, reflecting the respective performance of each individual portfolio component. The consequence is that, at any given point during the year, several stocks will likely represent more than 5% of the CSD.  To correct that inevitability, the CSD managers perform a portfolio re-balancing once each year. The filtering/selection process I described above is repeated, and a top to bottom repositioning is executed. CSD currently includes twenty-seven companies.  Not surprisingly, most of these companies range in cap size between small and mid-sized.

In the midst of CSD’s many appealing features, there are some elemental facts of which any CSD investor should be aware: [1]

1)    Although it is diversified over more than twenty-five companies and across a number of industries, this ETF cannot be considered “broadly” diversified;

  1. Just ten companies compose over 50% of its net assets;
  2. Fiesta Restaurant Group (FRGI) accounts for over 7% of the fund;
  3. Fortune Brands Home & security Inc. (FBHS), TripAdvisor Inc (TRIP), and Lumos Networks Corp (LMOS) are each more than 5% of the fund;
  4. The other five securities in the “top ten” are Howard Hughes Corp (HHC), Phoenix New Media Ltd ADR (FENG), Huntington Ingalls Industries (HII), Rouse Properties, Inc (RSE), Marathon Petroleum Corp (MPC), and Post Holdings Inc (POST).

2)    By far, the dominant industries currently represented in the CSD are energy, industrials, and consumer discretionary.

  1. Companies in the energy space compose about 23% of the ETF;
  2. Stocks within the industrial category make up almost 21%;
  3. Consumer discretionary issues total about 20% of the ETF;
  4. The other industries represented (each less than 10%) include: information technology, financials, materials, consumer staples, telecommunication services, and utilities.

3)    CSD has almost four million shares outstanding and the total asset value is over $147 million;

4)    Average market capitalization is $5.9 million;

5)    Average Price/Earnings Ratio is 18.8;

6)    Average Price/Book Ratio is 1.8.

7)    It’s expense ratio is capped at .60%, which is a bit higher than the average ETF expense ratio (in the low .40-range) but much less pricey than the average actively traded mutual fund (approximately 1.50%).

Since “a picture is worth a thousand words”, here are some telling views of CSD.

Above we see a longer term view of CSD (blue) vis-a-vis the S&P 500 Index. Note the steady outperformance early on, and then during the past two years. The “rough patch” for CSD occurred during the depths of the Mortgage/Financial Crisis, which impacted its smaller cap companies more than the much bigger S&P stocks.

Above we see a two-year graph of CSD vis-à-vis the S&P 500. Notice how much more impressive CSD looks when its struggles during the Mortgage/Financial Crisis are not on display!

Above we see CSD’s price action compared with a small cap index (represented by the IWM ETF). The outperformance of spinoff stocks is clear in this graph as well.

However, confirming the vital importance of MULTIPLE time frame analysis, we can see in the chart above that the outperformance of CSD relative to IWM (the Russell 2000 Index) is much less pronounced over a five-year period.  In fact, between spring of 2008 and some point around mid-2011, an investor would have fared better in IWM. However, that said, the CSD ETF can be a very useful investment tool for those who know the related rewards and risks.

Wrapping up, by now it is apparent that CSD is no investment “magic bullet”. It has its weaknesses, but thus far, it has provided its shareholders with impressive returns over the longer-term.

DISCLOSURE: The author is not invested in CSD or any of its component stocks, but has become very intrigued by the spinoff strategy and is actively considering adding it to his portfolio.  Note that all four stock charts were created through YahooFinance by the author.

Submitted by Thomas Petty

[1] Note that the ETF related data comes from Guggenheim Funds, as of mid-May

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