Richard Howe, how to invest in spin-offs and special situations?

Stock spin-offs can be very irrational priced by the market. The specialist Richard Howe helped us to understand this niche in investing.

The interview was done in 2020. We made it public now to give you more materials about our high-quality interviews at hand.

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Introducing Richard Howe

[00:00:00] Tilman Versch: Hello audience! I’m happily welcoming you back after I had a summer break. I hope you enjoyed the recorded videos I published. If you haven’t seen them, there’s some interesting insights on value investing in eastern Europe as well as a talk with Greggory Warren of Morningstar who gave great insights into good financial companies in the US.

Today I have Richard Howe with us. He’s located in a small town next to Boston. What’s the town called?

[00:00:36] Richard Howe: It’s called Wesley.

[00:00:38] Tilman Versch: Yeah. I already saw that on google maps when having our pre-interview and it looks nice to live there.

[00:00:47] Richard Howe: Yeah, it’s not the most existing town in the world but it’s fun. I have two young kids so it’s good if you have kids.

[00:00:57] Tilman Versch: That’s great. Kids often have questions and I hope this curiosity of kids is also in the room with our viewers. You are welcome to type in questions in the chat during our live streams so we can answer them.

Our topic today is spin-off investing and my first question is how you came into this field and what you did before looking at spin-offs. Before you answer the question, I want to just show a disclaimer that we are clear on the legal side. You can find the disclaimer below the video and the main message of the disclaimer is to do your own research. We will be talking about certain stocks and securities, but our conversation today is just our own opinion; it’s no advice or a recommendation. You have to do your own work and do it diligently. Thank you.

So, I’m happy to hear your answer.

[00:02:03] Richard Howe: You’ve given me a little time to prepare my answer, so I appreciate that. So, I have always been interested in investing. My dad was a large cap guy, a portfolio manager. That was his career, and he was a good teacher, so I had the benefit of being able to ask him a lot of questions and he gave me a lot of good books and he introduced me to Warren Buffet and Benjamin Gram and so that was a lot of fun. I’ve always been interested in investing and participated in my investment club in college and high school.

Richard’s initial investment journey

[00:02:47] Tilman Versch: What was your first stock?

[00:02:49] Richard Howe: You know what I don’t even my first stock because I remember it was 1999 and the internet bubble was happening, and my dad was a valley manager, so he was having a really tough time. So, just for fun I remember I had a little trader account and just for fun he suggested for me to buy a couple hot stocks. I think he was in just so much pain from investing in value stocks that he wanted to gamble a bit and so I remember we invested in a couple software start-ups, and they just tanked. It was like the top of the market, but other than that I remember I owned Gilette back in the day before it was acquired. That was one name that I owned. It wasn’t anything that was too interesting or unique, it was just big companies like that and then a highflyer or two that we suffered through once the bubble popped.

[00:04:02] Tilman Versch: So, you’re perfectly prepared for today.

[00:04:05] Richard Howe: Exactly. I don’t know it’s a little tough but anyways. After I gradated college, I started investing in a mutual fund company, so I did some equity research, and I was able to learn the business and work with some smart individuals. The problem was that we were investing in mega cap stocks, just big companies. At the time Apple was still pretty large. I think it represented 5% of the value index. At one point it was a value stock, and the game was really to compete with thousands of other smart individuals to try to pick the large cap stock. It’s a hard game to win and so we did our best with the funds that we managed but they couldn’t really outperform consistently. Not many actively managed mutual funds do, but I was always more interested in more unique situations, whether it was spin-offs, special situations or micro-caps that not as many people were looking at. So, that really led me to just look for more inefficient places to invest because it just seemed to me that investing in large caps was just too hard for me.

How Richard defines a spin-off or special situation in a stock

[00:05:32] Tilman Versch: So maybe let’s start with the basics. In your words, what is a spin-off or a special situation in a stock?

[00:05:42] Richard Howe: To spinoff is when a publicly traded company breaks up into two or more publicly traded companies. A good example was United Technologies earlier this year. United Technologies was a conglomerate. They had three divisions, one focused on airspace, one focused on a track called Carrier, and another division focused on manufacturing and servicing elevators called Otis. Due to activist pressure, United Technologies management decided to break up the one conglomerate company into three companies. So, if you owned 100 shares of United Technologies, after the spin-off was complete, you owned 100 shares of United Technologies, but you also owned a share of Otis, Elevator Corporation and Carrier. So effectively, it’s when a public company breaks up into two or more companies.

The reason why spin-offs tend to take place is because Wall Street likes simplicity. It’s hard to value a conglomerate. The more complex it is, the harder it is to value and it’s much easier for investors and Wall Street analysts to get an accurate read on financial trends and the underlying divisions and just the valuations that those divisions should garner once the companies are trading independently. So, that’s at a high level what a spin-off is and why people generally like them.

Why is it difficult for Wall Street to value these conglomerates or complicated companies?

[00:07:27] Tilman Versch: Why is it dificult for Wall Street to value conglomerates or complicated companies? There are so many bright guys and good investors. Why is it difficult for them to value these companies?

[00:07:45] Richard Howe: I don’t know the answer to that. You know what’s funny, I think in the ‘60s and ‘70s conglomerates were hot. Conglomerates with a lot of different divisions were viewed favorably. So, the conglomerates that were traded at 20, 25 earnings would buy smaller divisions at 10, 15 times earnings and they would get some valuation arbitrage by building the company up higher and higher and growing earnings that way and maybe we will get back to a point where that’s the case again. I don’t really have a good answer for it, but it seems that Wall Street and all investors do have a bit of a hard time with complexity.

I know we are going to talk about IAC a little bit later, but IAC was a perfect example. It’s an easy company to value prior to their spinoff from the Match group. They had an ownership interest in Match and ANGI Homeservices and a bunch of cash and it was easy to understand those because Mash was publicly traded and ANGI Homeservices was publicly traded as well, and cash was easy to value. Even though that was the case, that company traded at a big discount, like at a negative R2 billion-rand enterprise value ahead of the spinoff and it doesn’t really make sense why that’s the case. I don’t even know why it happens, but it’s an opportunity if you are interested at looking underneath the hood of these conglomerates.

How you can make money with spinoffs

[00:09:46] Tilman Versch: Interesting. Maybe we will find some studies someday where people find out why it happened, this strange valuation.

What are drivers for returns in spinoffs? How can you make money with them?

[00:09:45] Richard Howe: It’s interesting. One of the reasons that I like investing in spinoffs or just following potential spinoffs is because there’s a lot of different ways to make money. These transactions are usually announced 6 months to a year ahead of when they take place. Usually when a spinoff transaction is announced, Wall Street likes it because of the simplicity and the stock price usually pops by 15-20%, but then the spinoff euphoria will usually fade, and the stock will come back down to earth as the investor sentiment is stuck in a purgatory where the transaction is not going to take place for another year. There’s no need to own the stock a year before the transaction is going to take place. Often these companies that are going to be broken up are clearly going to be trading at higher valuations if they were to trade in line with their comparable peer set. Often you can invest in these companies ahead of the transaction. It’s like a reverse merger arbitrage where you know the transaction is going to happen next month but for whatever reason the stock price doesn’t reflect what it should reflect once the spinoff is complete. Again, Mash is a perfect example of that. Even a week before the transaction was going to take place, it was trading at a discount to what anybody would think the stock would trade at once the Mash spinoff was complete.

Someone may favor days when a spinoff takes place and it’s when a large company is spinning off a small subsidiary because often the shareholders of the large spinoff are big mutual funds or big index funds that really don’t have the mandate for owning these small spinoffs. So, they just sell them rather than doing work and deciding whether it’s worth owning this small cap stock. Maybe they’re even prohibited from owning some of these small spinoffs that they receive. Things to watch for are the first couple weeks of spinoff trading because if you have done the work ahead of time and you have identified a company that is attractive, you can just see these heavy waves of indiscriminate selling pressure and it’s just like a kid on Christmas. It’s just a gift because if you like the company and you feel comfortable with the valuation, it’s just a great way to be able to make some money because usually after the selling pressure dissipates, those spinoff stocks will snap back quickly.

In terms of the longer-term drivers of spinoffs and what determines whether they’re successful. It really depends on the underlying execution of the business. It’s no different than looking at any other socks. Things like revenue growth, margin expansion, earnings growth and free cashflow generation. All these things are important and ultimately you might get a good deal of buying a spinoff that just been sold indiscriminately, but if that spinoff doesn’t execute and doesn’t generate some revenue growth and operational improvement, then that spinoff won’t work well. It’s like evaluating any other company that you would look at in the stock market.

Richard’s take on whether management and capital and growth allocation generally improves after a spinoff

[00:13:33] Tilman Versch: In your opinion, does management and capital and growth allocation generally get better after a spinoff?

[00:13:43] Richard Howe: I think it will depend. In general, usually what happens is the management team of the spinoff company used to be a small division amongst a larger corporate bureaucracy and they’re able to have their own company. Not only that, but they’re compensated often in stock in that spinoff and so there’s a bit of an incentive for them to, instead of growing for growth’s sake, to actually try to create shareholder value because that’s going to benefit them. It’s really on a case-by-case basis. Some management teams are better than others.

Usually what I like to look for is the management team of the spinoff to have spent considerable time at the parent company or even running the division while it was part of the parent company. They know where the low hanging fruit is, and they know where they need resources that the parent company hasn’t given them. A good example is a company called Contour Brands which is a spinoff from VF Corp. Contour Brands makes jeans, so their big brands are Wrangler Jeans and Levi Jeans. They have some other brands, but they’re smaller and less well-known, but the entire management team from that company spent years at VF Corporation, which is a great company that generated great returns for shareholders, both through share buy-backs and dividends and so that’s something that I’m really looking for. Often, it’s “sexy” to bring in a new management team, but they usually don’t really know and don’t have the relationships and the institutional knowledge of the new company they are managing to be able to make fully informed decisions and to know where the low handing fruit is. I look for a management team that is familiar with the spinoff before they’re mandated with being the CEO of the company.

Recommended reading

[00:15:58] Tilman Versch: There are some questions from the chat. What reading would you recommend besides your blog?

[00:16:09] Richard Howe: Of course. Joel Greenblatt is the godfather of special situation investing. He has written several books, one of them being a book called “You can be a stock market genius”. That book is awesome. That’s the book that got me into special situations. The largest chapter is on spinoffs, but he also talks about other situations like write-offs, offerings, leaps and other sorts of options. That’s a really good book. If you just google Joel Greenblatt Columbia business school notes, a nice PDF of about 100 pages will pop up. He used to teach a class about special situation investment. That’s a nice resource as well.

There’s another old-school book by Marish[00:17:04] Shiller, and it’s called something like “Making Fortunes in the Stock Market”, or “Special Situations in Investing”, and that’s another good book that was written way before the Greenblatt book, but talks about many of the same principles.

Spinoffs from a “bad” company

[00:17:25] Tilman Versch: There’s a follow-up question from Edward Reilly. Peter Lynch wrote in one of his books that the parent company won’t spinoff a bad business because of potential reputational damage, but we know that there have been poor performing spinoffs recently. Why do you think this is the case?

[00:17:44] Richard Howe: Yeah, it’s interesting. Peter Lynch made the point which I think is a valid point that a parent company would not want to spin off a company and then have the company basically fail or go bankrupt, but there have been cases where this has happened. The most recent example is Honeywell spun-off a company called Gear Motion, which makes turbochargers and that business recently just put out a press release that they are restructuring the business. So, I don’t know if they’re going to do that. Part of the reason as to why they want to restructure the business is because they have a large asbestos liability that is a legacy from Honeywell.

It’s an interesting question and I don’t know why that necessarily is the case. I think perhaps it used to be that spinoffs were less well followed and to make the case that you should potentially keep the spinoff or invest in the spinoff, the parent companies had to ensure that the spinoff companies were on sure ground in terms of financial footing. Maybe in certain cases that’s not the case anymore where Honeywell said, “hey this is an opportunity to get rid of a bunch of liabilities, I’m going to saddle the spinoff with it”. A lot of investors follow spinoffs, so there’s going to be a natural buyer pool even though it’s going to have a lot of liabilities. That could be a reason, but I think it just goes to show that with spinoffs I think you probably would be okay if you bought every one of them. I think it’s much more prudent to pick and choose your spots because there are situations that you want to avoid where a company is perhaps a very cyclical company and has a high debt burden and an asbestos liability on top of it. It just makes for a tough situation heading into the later innings of the economic cycle which is when this company was spun-out.

When a bigger company spins-off a smaller company

[00:20:02] Tilman Versch: There’s also a question on the sell-off when a bigger company spins-off a smaller company. Is this still noticeable that the funds are selling the smaller companies’ funds because they don’t have the mandate?

Also, the question from the other side, if there aren’t enough funds on the other side that are actively buying these sold-off companies. How do you see the situation there? How long does it take for the selling pressure to go?

[00:20:37] Richard Howe: Yeah, good question. There are things you need to consider when you’re evaluating whether a spinoff might have a parent company, or a spinoff might have a lot of selling pressure. Firstly, if there’s a big difference between the expected market cap of the spinoff and the parent company, that’s usually a recipe for some indiscriminate selling. Also, if the parent company is in indexes, for instance the S&P500, S&P400 or is in some other indexes and the spinoff company is not going to be in an index, that can be another reason. If you read the form 10 which spinoffs publish before they begin trading in at least the US, often times the risk will be highlighted that they’re going to have a natural buyer base because they are not expecting to be in any indexes but their parent company is. That can usually be a clue that there might be some indiscriminate selling pressure.

In terms of when to establish a position, usually what I like to look for, in terms of my analysis, anywhere between 40% and 60% of the shares in standing I look to have traded before a stock is bottom. You want to see almost half the shares outstanding trade before it looks like the selling pressure has dissipated. That’s usually what I look for.

Another way to look for usually the share price. This will vary, but often the share price will decline anywhere from 40% to 60%. If a stock has gone down by 50% and 40% or 60% of the shares outstanding have traded, then I can be comfortable that the selling pressure has reached a low point. That’s usually a pretty good sign.

ETFs, and whether Richard thinks they have changed the game in recent years

[00:22:37] Tilman Versch: Have ETFs changed the game in the recent years?

[00:22:41] Richard Howe: They have exacerbated the selling pressure. Just the whole wave towards passive funds, more and more of the market is going to index funds and ETFs. More and more ETFs and the parent companies are held by passive institutions. This just exacerbates the selling pressure and makes it even more pronounced.

How you can lose money if you’re doing spin-off investing

[00:23:11] Tilman Versch: How can you lose money if you’re doing spinoff investing?

[00:23:16] Richard Howe: You can lose money. Like I said before, not every spinoff should be invested in. when you’re evaluating a spinoff, it’s good to do a fundamental analysis like you would on any other company or stock that you buy. Things that you want to look for is leverage, debt to equity, debt maturity and whether they have elongated debt maturities. Even if the company comes into a little bit of trouble, they are going to have the liquidity to make it through that downturn. You want to look at the rate of interest on the debt. Some spin-offs have debt that’s yielding about 10% or more, so if you see that it’s usually a negative sign. It just goes to show that debtholders in the current environment with 0% interest rates, and negative interest rates are requiring 10% or 12% interest from this company. This shows that the debtholders don’t necessarily view the spinoff company in the highest regard. That’s usually a red flag.

Other things that you want to look for is secular pressure and secular headwinds. With Garret Motion, they make turbochargers which internal combustion engines use, but electric vehicles are not going to need turbochargers. Companies with secular headwinds where the market is moving away from the product that they create are usually situations that you want to avoid. Debt is the biggest issue; secular headwinds is another big issue. Those are probably the two biggest red flags to look for when you are reevaluating a spinoff.

Spinoff machines in the stock market

[00:25:17] Tilman Versch: What are spin-off machines in the stock market that you know of?

[00:25:22] Richard Howe: So, IAC, which I mentioned earlier is a spinoff machine. I’m just referring to my notes. Just to take a step back, they are basically a holding company that focuses on internet and marketplace businesses and their most recent spinoff, which your audience may have seen in the news is Match.com. This is the biggest online dating company that was previously 80% owned by IAC, but they bought Match about 10 years ago, built it up through acquisitions and spun off of that business. Companies that they own that are going to be spun off at some point is AG Homeservices. They own 85% of that. They are going to spin that off. They own a video site called Vimeo. I know you use YouTube, but I use Vimeo for my site. That’s a great asset that I think will be very highly valued by investors once it does come public. Expedia, TripAdvisor, Ticket Master, Lending tree, are all companies that grew up under the IAC umbrella. IAC is definitely a spin-off machine

[00:26:48] Tilman Versch: Are there any other examples you know of?

[00:26:53] Richard Howe: Danaher spun-off Invista recently, which is a dental equipment business and I know that Danaher has historically been a very good business in terms of capital, allocational and operational efficiency. There’s another spin-off that Danaher did that I’m blanking on, but they’re another company that does spinoffs.

IAC and its uniqueness

[00:27:29] Tilman Versch: If someone knows it, please type it in the chat, so we can get the name. Let’s go back to IAC. What is unique about this company, besides the spinoff culture?

[00:27:47] Richard Howe: I would say there are a couple great things about IC. I’d say the most important factor is that a guy named Barry Diller is the chairman. He has been in the media and entertainment business since the ‘90s. He is an excellent capital allocator. So not only has he acquired good businesses, but he has also spun them out when it makes sense and when it will add value to the company. His capital allocation isn’t just buying and selling companies and spinning them off, but also buying back stock. Since 2007, the number of shares outstanding has gone down by I think over 50%. He just buys back the stock when it’s a bargain.

Behind IAC, one of the great books is the outsider CEOs and I think they’re 8 CEOs profiles and Barry Diller would be an excellent addition to that book because I think that the book argues that one of the most important things for CEOs to do is to allocate capital intelligently, to issue and buy-back stock at the right time, to make acquisitions and spin companies off at the right time. Barry Diller is in the hall of fame from a capital allocation perspective.

With most other companies you must wait year-round for their letter to shareholders. Some companies don’t even write a letter to shareholders, they will just issue their 10K. I really like reading the letter to shareholders, because it really gives you a good flavor for the company and what’s important and how the company is doing. IAC puts a letter to shareholders every quarter. It’s an intelligent and easy to read document on how the company is doing and what their vision is. That just makes it another company that’s fun to follow, because they’re just so clear as to what their vision is and how they are executing their vision.

SNX, and their upcoming spinoff

[00:30:17] Tilman Versch: One question from the chat. Another company, SNX, has an upcoming spinoff. Have you had a look at it?

[00:30:26] Richard Howe: Yes. They’re going to be spinning of their business called Concentrix in the second half of this year, really by the end of the fourth quarter. I’m still doing continued work on this company, but they do a lot of IT, they have an IT outsourcing division. They have a division that can help fortune 500 companies with their IT needs. If a company needs additional help to for instance install or service a software that they’re using, they can help with that. They also are an IT distribution company, where they act as a reseller and a distributor for other IT products. The interesting thing about this business is that it has historically performed very well. It still trades at a very cheap multiple. Last time I looked at it, they were trading at about 10X earnings, but the company has done a pretty good job and held a defensive position, through the financial crisis. The company grew revenue and earnings. It’s one that is on my radar. I haven’t completed my deep dive on it, but I like it at a high level.

Correlation between the return and incentives for spinoffs

[00:32:04] Tilman Versch: Interesting. So, there’s still some work to do and the people who want to see your results can go to your blog and subscribe to see them.

There’s a question on the correlation between the return and incentives for spinoffs. Do you have anything to mention about this correlation?

[00:32:28] Richard Howe: Yeah, so one big thing that Joel Greenblatt talks about is incentives and following those incentives. When you read a form 10, you can usually see how many shares are reserved for executive compensation and Joel Greenblatt makes the point that the higher that number, the better. Even we know that the company is going to get diluted, the management team is going to have a bigger incentive to actually increase the stock price because they are going to benefit through options and restricted stock.

I don’t have a specific correlation between how incentivized a management team is and the shareholder returns. My sense is that it would be very highly correlated. There are going to be certain exceptions to the rule. For instance, KLX was an energy services spinoff that had an excellent management team who had created a lot of shareholder value in the past, and they decided to forgo salaries in exchange for getting equity in the new spinoff company. Even though incentives where perfectly aligned and the management team had every incentive to increase shareholder value, the company has done horribly and it hasn’t been an issue with the company but more the energy world has been a tough place to be in, especially the energy services industry. It’s something that I look for and I’d say it is the most important factor when I’m evaluating a company.

Other times you must read between the lines. For instance, a tiny micro-cap spinoff way back in the day was called Liberated Syndication and it’s an interesting company. Full disclosure, I own some shares, but it’s a podcast hosting company and it was spun out of a company that had almost gone bankrupt because of Chinese fraud. There’s a huge taint having to do with this company and on top of that, the management team of this spinoff didn’t own any shares. The financials looked really good. It was trading at like 2- or 3-times earnings, and the business was real for my due diligence. I thought that it was a leading podcast host, and that many people used this podcast, so I didn’t think fraud was an issue for this division. If you just followed incentives, you would have said I can’t invest in this because the management doesn’t own any stock. What I thought would happen and Joel Greenblatt hints at this too, is that part of the reason why they weren’t promoting the story and talking to investors was because they were going to issue themselves a lot of stock and they wanted the stock price to be low so that they could issue themselves lots of shares, and that’s exactly what happened. Often you must read between the lines. One thing that Joel Greenblatt does mention is that, often the management teams will want to grant themselves stock before they go and promote the spinoff and that doesn’t happen all the time, but it does happen occasionally, so it’s something to be aware of.

Richard’s spinoff process

[00:35:58] Tilman Versch: Then it’s a chance to invest in the management at this point so you have the best promoters working for you. It’s a quite good incentive in this case.

Let’s look a bit at your process. How many spinoffs do you have a look at every year, and how many do you invest in? And what’s the return you get out of that? So that’s three questions, so maybe let’s start with the first.

[00:36:25] Richard Howe: So far, this year, there have been 12 spinoffs in the US and my primary focus right now is all the US spinoffs. I know you have a big German audience, so if there are interesting spinoffs in Germany that are happening that people want me to have a look at, shoot me an email.

I am primarily looking at US spinoffs. Every US spinoff that comes out, I will do a deep dive into. Basically, read through the form 10, try to talk to investor relations or the management team if I can, and listen to the analysts and their presentations. By doing these things, I try to get a sense if this is a company that I would want to invest in, at the right price. If it’s a company that you want to invest in, at the right price, hopefully it will be a spinoff that experiences some indiscriminate selling pressure and so, you’ll be able to buy it from shareholders that are just forced to sell for no other reason than they don’t have the mandate to own small-cap stocks. That’s the ideal situation.

So far this year there have been 12 spinoffs, but in addition to that, I’m always looking at prior spinoffs, which are spinoffs that have happened in prior years and whether those are looking attractive and whether the fundamentals are looking attractive or whether they are still ones to avoid. That’s really my process, to really do my work ahead of time and try to get a sense if this is a spinoff that I would want to own at the right price. Once I’ve done that, I have that wealth of experience to fall back on to revisit at various points. Gary motion[00:38:07] is a spinoff that I have continued to track and have been tempted to invest in, but so far, I’ve held off. That’s an example of a 2018 spinoff that I’m keeping track of. Coolpoint Lodging[00:38:21] is another spinoff that took place in 2018, I think. It was basically the break-up of the Laquinta brands and the real estate portion of that company. So that’s another spinoff that I continue to monitor.

In terms of my recommendations, I generally have about no more than 10 individual open recommendations at any point in time. My closed recommendations generate a 24% return on average. My open recommendations are a little bit lower than that. I do have some energy exposure unfortunately, which has been a bit of a headwind.

The other interesting thing that is another reason why it pays to follow spinoffs, is that often you will find these special situations. A company will be spun off through what’s called a split-off. Just to give an example, Danaher spun off a company called Invista, which is dental equipment business. The way they did it was through a share exchange. So, if you were a shareholder of Danaher, you could exchange your Danaher shares for shares of this new company, Invista. What is the motivation for exchanging your Danaher shares for the shares of a small company? The motivation to incentivize Danaher shareholders to exchange their shares, you could get basically those shares at a 7% discount. It’s basically a free 7%. Obviously, those situations are heavily over-subscribed because it’s a free 7% and, in the market, there’s no such thing as a free lunch.

For Odla[00:40:07] shareholders who own fewer than 100 shares, their allocation wouldn’t get pro-rated. You wouldn’t get cut-back in your allocation even though it was heavily over-subscribed. These spinoffs are short trades. They can be a month or even two weeks, but it’s a way to make $1000 in a period of a couple of weeks with minimal risk. I sprinkle in a couple recommendations like that every so often when I see them. Just because they’re interesting and that’s a way to make a low-risk profit over a reasonably short period.

The difference between the best and worst spinoffs

[00:40:55] Tilman Versch: Those are some very interesting situations, especially if you can use them. Also in Germany, there’s a special law where if you’re buying a stock and the fair value is above, you can go to the court and get a revaluation. You also get some interest of I think 6% for the time that you’ve waited for the re-valuation. So, it’s quite a clever way of making some money and some people are specialized in that.

There are some more questions from the chat. What is the difference between the best and the worst spinoffs that you’re looking at? How do you choose to be picky between them?

[00:41:38] Richard Howe: So, the best spinoffs can be more than a 100%. Liberated Syndication is a micro-cap spinoff. It’s over 10x from the time that it was spun-off. Obviously, that’s not for everybody because it’s a small company. The worst situations are companies that have gone bankrupt. There are spinoffs that have gone bankrupt and so, the variation between the best and the worst is very high. In terms of choosing the best spinoffs, what I’m looking for is what you would look for in any business which is a good business with secular tailwinds, opportunities for market expansion, free cashflow generation and a really good management team.

Often, you’re not going to find everything that you’re looking for. In the case of Liberated Syndications, it’s a great business with secular tailwinds, trading at a dirt-cheap valuation, but the management team was very sketchy. You had to get comfortable with the management team before taking a flyer on that company.

Another company, like Contour Brands, is a jeans manufacturer, so that’s not the sexiest company by any means, but it’s a pretty capital efficient business. There aren’t really high needs for that cap-ex business. The brands aren’t super sexy, but they have staying power. There’s a lot of brand value there. I think people are going to be wearing jeans in 100 years. I don’t think jeans are going to go away. At the same time, if you can get a business like that at a really attractive valuation, then that’s also a good place to be.

In general, I’m looking for businesses with at least stable industry outlooks or hopefully a little bit of industry tailwind. I’m trying to avoid those secular tailwind situations or those companies with a lot of debt because those can obviously get to zero in a hurry.

Valuing environmental and asbestos liabilities

[00:44:09] Tilman Versch: There’s also a question about liabilities, specifically environmental and asbestos liabilities. How do you evaluate them?

[00:44:17] Richard Howe: There’s asbestos liabilities with Garrett Motion and the way that I evaluate those is essentially I just look at it as debt. I think the maximum that Garrett Motion will have to pay in any one year to Honeywell is capped at $140 million to $170 million per year. That liability isn’t going to away. I think it’s a 30-year liability. So, it’s a meaningful liability. In the form 10, I haven’t looked at it recently, but they estimated that the fair value of that estimated asbestos liability was I think like $1.2 billion. The way that I thought of, and valued Garrett Motion was that I added the debt to the enterprise value, but I also added the asbestos liability. It’s a liability that’s not going to go away until that asbestos liability goes to zero. That’s the way that I think of the asbestos liability.

The tools that Richard uses to value spinoffs

[00:45:43] Tilman Versch: In your toolbox for valuations, what are your most common tools to value spinoffs?

[00:45:52] Richard Howe: It really depends on the situation. I think you have to be flexible. For instance, some spinoffs that I’ve invested in the past, such as biotech and med-tech spinoffs, where due to indiscriminate selling pressure, the stocks were trading below cash on the balance sheets. So, they were essentially trading at a negative enterprise value and of course these companies were burning cash. To some extent there was a reason why they were trading below cash, but they also had revenue, approved products with revenue that was growing. Even factoring in potential cash-burn, the way that I thought about those companies was, let’s look at what a comparable company would trade in on an EV to sales basis because none of those bio-tech companies are making any money and let’s get a range of outcomes for what’s a reasonable valuation and what’s an expensive valuation and compare it to where the stock is trading. In both cases, both companies, one being New Vector, which is a more of a med-tech company and the other, Activo, which is more of a bio-tech company. In both of those situations we were able to buy them way below cash on the balance sheet and then ultimately as revenue grew, both companies spiked up and we were able to take a profit.

This gets back to the point where the outcome of the spinoff will depend on the business itself. Both of those companies have subsequently done poorly. New Vector has actually gone bankrupt, so they had a hiccup in their revenue growth in their new product launch. We were able to make 100% on our money before that happened. Activo is still alive, but the company is struggling along. They have wanted to get some partnership with some big pharma companies but that just hasn’t materialized. Ultimately, the success of the company is going to depend on the fundamentals of the business but if you can buy a company below net-cash on the balance sheet, odds are that you’re going to do well. If it’s a company like Contour Brands which is an apparel company, you can look at it on a price to cashflow basis, on an EV to EBIT basis and on a price to earnings basis.

I usually look at all those different multiples versus peers to see where the business is trading. For some companies like Contour Brands, they also do a discounted cashflow analysis to just get another data point in terms of what the fair value might be. This isn’t always the case, but if there have been acquisitions in the space, then you can also use preston transactions to say, peer companies have been acquired at say 15 times deep so that could be a reasonable gauge for where this company could trade as well. It really depends on the company. I like to use comparable whether its price to cashflow, EV to EBIT, but if it’s like a money losing company, you might have to use an EV to revenue or EV to sales multiple.

Holding your position when investing in spinoffs

[00:49:12] Tilman Versch: It’s the last call for questions. If you have any questions, please type them in the chat. There’s one good one I want to pick up from Paul. How long do you hold your positions when you’re investing in a spinoff?

[00:49:28] Richard Howe: Good question. It really depends. If it’s a company like New Vector, where it’s selling below cash on the balance sheet and then it gets hot and people get excited and bid it up, and it’s just very volatile, I’ll have no problem selling out the stock within a month or two or even within a week or two. Usually, my expected timeframe is a couple years. The ideal situation is it’s a company that’s in a good business, that’s going to grow earnings and its cashflow and revenue and it is trading at a cheap valuation. Over time earnings can grow, but the multiple can also expand and so you can really get a multi-bagger but if a stock goes up by 1500% in a month or two, I have no problem taking a profit there. The one caveat is the special situations that we talked about where you can make around $1000 bucks in a month. Those are usually my shorter-term recommendations where they’re self-liquidating in a way. Those will always stay open for about a month at most.

Companies merging with divisions of bigger companies

[00:50:45] Tilman Versch: Interesting. There’s another question on SPACS that are merging with a division of a bigger company. Is that also a kind of spinoff? Do you look at these situations?

[00:51:00] Richard Howe: Yeah. It’s a crazy environment that we are in right now, where SPACs are trading above the cash on their balance sheet. I’ll keep an eye on those types of situations. Usually if there’s a lot of hype on those types of situations where a SPAC is acquiring a division of another company, usually that company is pretty highly valued by the acquisition vehicle. I will look at every individual situation on its own, but usually the ideal situations are when the spinoff takes place through a distribution because you’re not going to have a natural shareholder base and so you’re going to have selling pressure for no reason other than because a shareholder can’t own a small cap stock. Those are the situations that I prefer, but I definitely will keep an eye on spinoffs that have been through IPO and SPAC acquisitions as well.

Interesting people to follow relating to spinoffs

[00:52:04] Tilman Versch: Who are you competing with? Who are the other players in the spinoff space? Are they a specialized hedge funds or smaller funds? Who is interesting to follow?

[00:52:14] Richard Howe: Good question. There are a lot of good people to follow. I’m on Twitter and I just find tremendous value from being on Twitter. There is a ton of people that are generous with their ideas and what they’re sharing. If you’re not on Twitter I would highly recommend joining Twitter. I’m just going off the top of my head, but “Value with a Catalyst” is someone I follow. He covers a lot of special situations, and he will highlight situations that he thinks is interesting. That’s definitely someone I would recommend following “Clark Street Value” is another blog. I think he’s also on Twitter. He posts a lot of interesting write-ups. He has a really good track record as well. Andrew Walker is another value blog. He posts a lot of stuff, and he is generous in terms of the stuff he puts out there. If you’re curious, send me a message @stockspin-offs and I’ll give it some more thought and follow-up with some more recommendations because I’m just going off of the top of my head. There are a lot more people that are really generous in terms of what they’re willing to share.

[00:53:42] Tilman Versch: You can send me the names and I will put them in the show notes afterwards.

[00:53:57] Richard Howe: That sounds great. I’ll do that.

Where Richard sees the most interesting situations in the spinoff space

[00:53:46] Tilman Versch: Great. To finalize our talk, where do you currently see the most interesting situations in the spinoff space?

[00:54:02] Richard Howe: Right now, I think that investing ahead of the spinoff is interesting. A couple examples, one we already mentioned is IC. leading up to that spinoff transaction, you were able to buy IC for an applied negative enterprise value based on where the stock should trade.

There are a bunch of other situations that look interesting. Pfzier is going to be merging with Mylan and that company is going to start paying a dividend. Dividends, ETF, index funds are going to have to buy that fund. It’s going to be that indiscriminate buying pressure. Based on their latest disclosure and Mylan’s stock price, it looks like it’s going to be a 5% yield. So that’s going to be a pretty juicy yield, so I think that one could be an interesting situation.

Nielsen is another company that is going to be breaking up that looks pretty inexpensive to me. Where I’m seeing the most value is really investing ahead of the break-ups, because once I said, once there’s a spinoff transaction announced, usually there’s a huge pop due to the spinoff euphoria. Then the enthusiasm fades as more time passes and everybody forgets about why they were excited to begin with. So, if you can wait until a month or two before they’re about to take place, usually there’s a good reverse arbitrage opportunity.

[00:55:35] Tilman Versch: That’s interesting. Do you have something to add, that we didn’t discuss?

[00:55:43] Richard Howe: I think we covered most of it. Come to my side, I have a spinoff calendar which you can use to monitor the coming spinoffs and if you have any questions, shoot me an email at rich@spinoffsinvesting.com or just shoot me a message on Twitter and I’d love to interact with other people. If you have any interesting ideas, I always love comparing notes.

[00:56:16] Tilman Versch: You must follow this guy on Twitter, and me as well! Thank you very much for your time and thank you very much to the audience for the good questions. It was very helpful to get these insights. Thank you very much. Enjoy your day or evening, if you’re in Germany.

[00:56:38] Richard Howe: Thank you Tilman. This was great.

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