The main reason is that the indiscriminate selling pressure associated with spin-offs allows me to buy bargains.
Why do spin-offs sell off when they begin trading?
Seth Klarman of the Baupost Group explains why this dynamic exists in Margin of Safety:
“Many parent-company shareholdings receiving shares in a spinoff choose to sell quickly, often for the same reasons that the parent company divested itself of the subsidiary in the first place. Shareholders receiving the spinoff shares will find still other reasons to sell: they may know little or nothing about the business that was spun off and find it easier to sell than to learn; large institutional investors may deem the newly created entity too small to bother with; and index funds will sell regardless of price if the spinoff is not a member of their assigned index.
For reasons such as these, not to mention the fact that spinoffs frequently go unnoticed by most investors, spinoff shares are likely to initially trade at depressed prices, making them of special interest to value investors. Moreover, unlike most other securities, when shares of a spinoff are being dumped on the market, it is not because the sellers know more than the buyers. In fact, it is fairly clear that they know a lot less.”
I’ve taken advantage of indiscriminate selling to make lots of money on Kontoor Brands (KTB), Nuvectra (NVTR), and many others.
Jackson Financial (JXN) and Sylvamo (SLVM) are two other indiscriminate selling candidates that I’m watching closely.
But did you know that you can actually short spin-offs and get ahead of the indiscriminate selling pressure?
The catch is it’s fairly capital intensive to do so, but it is possible.
Short the parent company
Buy the parent company stock in the when issued market.
You are effectively short the imminent spin-off.
Let’s take an example.
J2 Global (JCOM) will spin off its eFax business on October 8. The spin-off is named Consensus and will trade under the symbol CCSI.
The spin-off is trading in the “when issued market” at an implied valuation of 9.5x 2021 EBITDA which I think is expensive.
What’s the “when issued” market?
It’s basically a pre-market for the spin-off with limited volume to get a sense of where the stock should trade.
You can buy and sell the stock in the when issued market, but it won’t settle until regular way trading begins.
So here’s how you would short 100 shares of Consensus.
Short 300 shares of J2 Global (JCOM) at $138 (spin-off ratio is 1 share of CCSI for every 3 shares of JCOM).
Buy 300 shares of RemainCo in the when issued market.
The caveat is that RemainCo is changing its name from J2Global to Ziff Davis.
The ticker to buy Ziff David (RemainCo) in the when issued market is ZDVSV.
So in this example, you would buy 300 shares of ZDVSV at $118.
Once the spin-off happens, your long and short positions in RemainCo will offset and you will be left with a 100 share short position of Consensus (CCSI) at a cost basis of $63.
Consensus should experience indiscriminate selling given it’s a smaller market cap than the parent ($1.2BN vs. $6.1BN), is heavily indebted and has no organic growth (3% growth YTD was due to acquisitions).
I think Consensus is probably worth around $35 which implies 7.2x ‘21 EBITDA.
The one caveat to shorting spin-offs is it takes a lot of capital.
To establish a $6,300 short position in Consensus, you have to buy $35,100 of ZDVSV and then short $42,400 of JCOM. Most brokers will let you use some of the proceeds from your short position to buy stock, but usually not all of it.
As such, it’s capital intensive to short spin-offs prior to regular way trading.
Nonetheless, it can be profitable.
My preferred approach is to identify spin-offs that 1) will be sold indiscriminately and 2) would be attractive at the right valuation (competitive position, growth potential, etc.).
Consensus fits criteria #1 but fails #2.
When you find spin-offs that meet both criteria, it can be quite profitable.
In fact, I just recommended a name that is experiencing indiscriminate selling pressure but is very undervalued on an absolute and relative basis. Furthermore, an imminent dividend initiation is likely to force the stock to re-rate.