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Why spinoffs reward investors

Studies have shown they tend to out-perform because of several energizers.

General Electric Co. and Johnson & Johnson – a pair of sprawling Fortune 500 conglomerates – are in the news as they spin off some operations in response to shareholder pressure.

GE (GE-N), which has struggled for more than a decade, listed shares of GE Healthcare Technologies Inc. (GEHC-Q) on Jan. 3 as the first part of its plan to split into three pieces. A few days, later Johnson & Johnson, (JNJ-N) confirmed it’s doing a similar thing with its consumer products division later this year.

Closer to home, Brookfield Asset Management Inc. split into two entities just before Christmas, changing its name to Brookfield Corp. (BN-T) and issuing shares of a newly created asset management business called Brookfield Asset Management Inc. (BAM-T)

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Both GE and Johnson & Johnson are spinning off well-established multi-billion dollar entities and retaining majority stakes. GE is keeping 80 per cent of GE Healthcare with the rest given to GE shareholders in a tax-free distribution. GE Healthcare has a revenue of US$18-billion and makes medical equipment including X-ray, mammography and ultrasound machines.

Johnson & Johnson will also keep 80 per cent of the renamed consumer unit to be called Kenvue. Kenvue has US$15-billion in revenue and markets over-the-counter brands such as Band-Aid, Listerine and Tylenol.

Hilbert Wan is a healthcare analyst with Purpose Investments Ltd. in Toronto. Credit: Supplied Photo

Studies have shown that spin-offs tend to be good bets for investors. While not all of them outperform, many do because of several energizers. The businesses are well developed with a track record, unlike initial public offerings (IPOs). The parent companies are often the biggest shareholders and so have an incentive for them to succeed. The spin-offs have experienced management teams that can be more agile once they’re out from under the bigger umbrella.

‘Ask why spin-off is happening’

“[Spin-offs] offer a lot of opportunity for investors who want to take a closer look and do their homework,” says Hilbert Wan, health care analyst and trader with Purpose Investments Inc. in Toronto. “If they do so, I think they can find alpha.”

Paul MacDonald, chief investment officer and portfolio manager at Harvest Portfolio Group Inc. in Oakville. Ont., adds that a case-by-case evaluation is important.

“Ask why the spin-off is happening and look at the prospects of the company,” he says. “What is the involvement and support of the parent? Do they have the resources to draw upon if needed?”

High-profile spin-offs in the past decade include eBay Inc.’s spin-off of PayPal Holdings Inc. PYPL-Q, Expedia Group Inc.’s Tripadvisor Inc. TRIP-Q and drug manufacturer Abbott Laboratories’ AbbVie ABBV-N. Pfizer Inc. has several under its belt, including Zoetis Inc. ZTS-N , which was once its animal pharmaceutical unit.

Some less successful spin-offs are Telus Corp.’s 2021 spin-off of Telus International Inc. TIXT-T, which provides information technology (IT) services and customer service to companies such, as Uber Technologies Inc. and Fitbit.

Its shares surged after the IPO, but are 25 per cent below that level two years later. IBM Corp.’s 2021 spin-off of Kyndryl Holdings Inc. KD-N which also offers IT services, has had the same trajectory. It has sold off more sharply, falling 70 per cent from its spin-off price.

Mr. Wan says the trigger for a spin-off is often a strategic review, which is the case with Johnson & Johnson. About 80 per cent of Johnson & Johnson’s revenue comes from high-growth drug development and medical technology. The remainder is from slower-growth established consumer products.

“The cost of growing that other 20 per cent is high and will not move the top line needle much,” he says.

The drawbacks of spin-offs

There are many pluses with spin-offs, but there are also drawbacks. The smaller new company may not be able to attract the talent it needs and has fewer resources to draw on. Closer scrutiny among investors means more share price volatility. Mistakes that might go unnoticed in a conglomerate become magnified.

Investors often find an opportunity soon after the split. The price of the shares may not reflect their actual value. Downward pressure can come from shareholders who were given shares as part of the parent’s distribution and don’t want them.

Paul MacDonald is Chief Investment Officer at Harvest Portfolio Group. Credit: Harvest Portfolio Group

“There’s an element of the unknown in the share price initially,” Mr. MacDonald says.

He adds Harvest typically waits two or three quarters before investing in spin offs. It owns AbbVie and Zoetis in its Harvest Healthcare Leaders Income ETF. HHL-T.

There’s one exchange-traded fund (ETF) that offers investments in spin-offs: The former Guggenheim Spinoff ETF, now Invesco S&P Spin-Off ETF CSD-A. It was renamed following Invesco’s acquisition of Guggenheim Partners ETFs in 2018.

It has US$55-million in assets and invests 90 per cent of its holdings in the S&P U.S. Spin-Off Index, which is composed of companies that have been spun off within the past four years.

The ETF’s top holding is Otis Worldwide Corp. OTIS-N, the elevator company formerly part of Raytheon Technologies Corp. Dow Inc. DOW-N, the material science company formed from the breakup of the DowDuPont chemical conglomerate is second. The third is Corteva Inc. CTVA-N, the chemical and seed company that’s also a DowDupont spin-off.

The fund’s price declined 15 percent in 2022, slightly better than the 19.4 percent decline in the S&P 500 index.

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