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Value investors, following the Ben Graham approach to investing, like to invest in companies that are obscure and undesirable which, because of that, tend to be mispriced by the markets. These are small-cap companies that are not covered extensively by analysts and tend to have low price-to-earnings or price-to-book ratios. In general, this is common knowledge. What is less known, however, is that value investors additionally have an interest in spin-offs, which also create mispricing due to a supply-demand imbalance.

Investopedia defines the term as "the creation of an independent company through the sale or distribution of new shares of an existing business or division of a parent company. A spin-off is a type of divestiture." In other words, in a spin-off, a division or a unit of a company is separated from the parent company and becomes a new company. For example, in September, 2013, Altria Group Inc. spun off Philip Morris International Inc., which became a separate entity. Since the Great Recession of 2008-09, there have been 38 spin-offs in North America and Europe, according to DZ Bank.

Value investors find spun-off companies attractive. And spin-offs have rewarded investors handsomely. Empirical evidence shows that spin-offs have outperformed benchmarks. The Bloomberg spin-off index has returned around 300 per cent since 2006, while the S&P U.S. spin-off total return index has returned close to 270 per cent, well outperforming the S&P 500 total return index, as well as both the S&P value and growth stock indexes.

But what is it that makes spun-off companies so attractive to value investors?

Spin-offs create a temporary imbalance in the supply and demand of the shares of the spun-off unit, with supply exceeding demand. Excess supply creates downward pressure on the spun-off unit's share price, allowing an investor to enter the stock at a depressed price. How is this?

First, shareholders of the parent company, normally a large-cap stock, who now receive shares in the spun-off unit may know very little about the new company, invariably a small-cap stock, and so they may be motivated to sell the new company. Moreover, lack of knowledge about the new company depresses demand for its stock. This is exacerbated by the fact the new company is not as yet covered by analysts, who may not start covering the stock for months after the spin-off.

Second, institutional investors may find themselves holding the new company that does not fit their mandate and so they are also motivated to sell. More supply than demand puts downward pressure on the new company's stock in the wake of the spin-off.

What will be the catalyst for a stock-price recovery?

The parent company usually has an interest in making sure the new company is a success because many times it maintains a stake in the new entity. Moreover, the spun-off company, due to its new management, has greater flexibility to pursue investment opportunities. It is less complex, likely a pure play, has fewer overhead costs than the parent company and can tie better management performance to compensation.

The new unit may also have better financial flexibility and ability to access the credit markets than the parent company. A spun-off real estate unit, for example, may be able to raise more capital and on better terms as an independent company; as part of a conglomerate it may be hampered by the parent's overall creditworthiness and capacity to raise debt.

Finally, depending on how successfully the spun-off company is run by the new management, the stock may start to be covered by analysts, thus attracting the interest of institutional buyers and index funds, as a result.

How can a retail investor with limited investing experience and time take advantage of this knowledge? Through ETFs that specialize and invest in spin-offs.

Unfortunately, as far as I know, there are only two of them. The Guggenheim S&P Spin-Off ETF (CSD) is the oldest – and until 2015 the only ETF – focusing exclusively on spun-off companies.

The other ETF, established in mid-2015, is the VanEck Vectors Global Spin-Off ETF (SPUN). Over the past 12 months, CSD has gained 19.4 per cent while SPUN has advanced 26.3 per cent. Over the same period the S&P 500 rose 15.4 per cent.

It's no wonder that value investors, always on the lookout for temporary mispricing of stocks in the market, keep spin-offs on their radar.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

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