Making money from spin-offs on the JSE

A new report by Urquhart Partners (available here) shows that spin-offs have historically been a lucrative market segment in which to invest, having outperformed the broader JSE over the timeframes that were examined.

Urquhart Partners is a new investment company founded by former Protea Capital Management senior investment analyst Richard Cheesman.

It focuses on special situations on the JSE, including spin-offs, unbundlings, acquisitions, delistings, activist investments, and capital raises.

Spin-off securities fall into the broader stable of special situation investments when companies undergo a material change.

These material changes include mergers, spin-offs, restructurings, and management changes.

The report from Urquhart Partners focussed on spin-offs, which the authors highlighted differ significantly from regular unbundlings and Initial Public Offerings (IPOs).

Both unbundlings and spin-offs involve a parent company distributing shares in another company to its shareholders.

However, a spin-off results in the distribution of the shares of a company that was not already listed. This distinction is crucial.

Newly listed companies have more unknowns compared to existing listed companies, which have established shareholders, proven histories, and known market valuations.

This uncertainty linked to new listings often results in lower initial valuations that can lead to increased future performance.

The main difference between an IPO and a spin-off is that only those who want shares in a new listing subscribe to its IPO.

With a spin-off, all existing shareholders of a parent company indiscriminately receive shares in the newly listed company.

IPOs are typically conducted for more popular companies, which command higher valuations. Spin-offs are often conducted for less popular subsidiaries.

This contributes to spin-offs frequently having a lower starting valuation and achieving higher subsequent returns.

A spin-off can be combined with an IPO. However, most of the spin-off’s shares usually end up in the hands of the parent company’s shareholders.

Spin-offs are relatively rare on the JSE, although there has been a steady stream of these over time.

Last year was the only year since 2011 without any spin-offs on the JSE. More recently, WeBuyCars and Rainbow Chicken made headlines as high-profile spin-offs.

It raises the question of whether spin-offs are worth investigating as an investment option. The answer is ‘definitely’.

As a group, spin-offs on the JSE have historically significantly outperformed the index over six, twelve, twenty-four, and thirty-six months following being spun off.

It should be noted that outliers, particularly Thungela and Montauk, drove this performance. These outliers underscore the potential within this niche.

When these outliers are excluded from the impacted period, the pool of spin-offs underperforms the index in the short term, likely due to selling pressure.

It takes time for the management teams’ actions to make an impact and for the market to recognise the mispricing.

This seems to lead to outperformance over two and three-year horizons, albeit by a much-reduced margin.

The research further found that spin-offs that constituted a smaller proportion of the previously combined group have performed especially well.

Returns from parent companies have historically exceeded that of the index before a spin-off, but not afterward.

“Successful exploitation of this niche hinges significantly on effective stock selection,” Urquhart Partners said.

The chart below, from Urquhart Partners’ report titled “Past, present, and future of spin-offs on the JSE”, shows the performance of spin-offs over different periods.