[If you have] ever seen a strange, odd-lot [or not] position appear in your brokerage account and not have a clue where it came from...you’ve most likely received "spin-off" shares [where]...a parent firm distributes shares of a spun-off subsidiary to parent shareholders...From an investing standpoint, most investors — amateur and professional alike — sell these shares after noticing the new position...but, investors who blow out spin-off shares soon after receipt are often making a costly mistake...Don’t Sell Those Spin-offs: They Tend to Outperform! [Let me explain why that is the case.]

Written by Grant Wasylik

Many academic studies have confirmed that spin-offs outperform the overall market by a large margin:

  In a study of 168 large ownership restructurings from 1988 to1998, spin-offs substantially outperformed the market. They showed a two-year annualized return of 27%, compared with 14% for the Russell 2000 and 17% for the S&P 500. — The McKinsey Quarterly

  Between 1965 and 1994, a sample of 174 spin-offs returned an average of 18% in the first year, 51% in the first two years and 76% in the first three years outpacing the S&P 500 by 31%. — Professors James Miles and Randall Woolridge of the Penn State Smeal School of Business

  From 1985 to 1995, research on 77 spin-offs showed that during the first 18 months of trading, the average spin-off beat the stock market by more than 20%. — JPMorgan

These studies are somewhat dated, but more recent data shows that the same story still holds true - Spin-offs, as a group, outperform the broader stock market.

Over the last 14 years (from Dec. 31, 2002, to Dec. 30, 2016), the Bloomberg U.S. Spun-Off Companies Index returned +714%, while the S&P 500 Index returned +155%, and check out the consistency of calendar-year outperformance over the last decade:

The S&P U.S. Spin-Off Index easily outran the S&P 500 Index in eight of the last 10 calendar years. (Including almost doubling up the index in 2016.)

Why Do Spin-offs Prosper?

I reached out the other day to the foremost expert on spin-offs, Joe Cornell, the founder, president and controlling principal of Spin-Off Advisors LLC...who told me:

"Spin-offs often result in a higher aggregate value for the constituent pieces.

"Many diversified companies are electing to spin off parts of their business, finding that this restructuring technique can create significant value for shareholders. There were 35 spin-offs in 2016 (worth about $100 billion in initial market value).

"Why do spin-offs prosper?

"Much of the impressive performance comes from the altered dynamics of the spun-off business and its parent. Spins do well partly because when a business and its management are freed from a large corporate entity, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course. Managers have greater freedom to pursue new ventures, streamline production, and pare overhead. After the spin-off, stock options can also more directly compensate management of the new company.

"This often leads to improved operating performance over time. When one reconstitutes the parent and spin-off after a one to- two-year period, often outstanding overall returns are observed."

So, how can you take advantage of the spin-off phenomenon? Other than leaving your next spin-off position alone, there’s another simple, one-click way: the Guggenheim S&P Spin-Off ETF (CSD), launched on Dec. 15, 2006, [which]...has beaten the S&P 500 over the previous one, five and 10 years...[and] a recent index switch on May 20, 2016 — from the Beacon Spin-Off Index to the S&P U.S. Spin-Off Index — may aid return improvement going forward. 

CSD’s new index, which has outperformed its old index over time, measures the performance of domestic companies that have been spun off from larger corporations within the past four years. It includes companies derived from different types of spin-offs:

  Traditional spin-offs: Parent firm distributes shares of a spun-off subsidiary to parent shareholders.

  Carve-outs: Parent firm sells a percentage of the subsidiary to public shareholders.

  Split-offs: Parent company offers shares of the subsidiary in exchange for the parent company’s shares.

According to CSD’s prospectus, the S&P U.S. Spin-Off Index’s construction works like this:

1. The Index is comprised of equity securities added to the S&P United States Broad Market Index that have been spun-off and have a float-adjusted market capitalization of at least $1 billion.

2. The Index is weighted by float-adjusted market capitalization, subject to a maximum weight of 7.5% for any single stock.

3. Additions to the Index are made at each monthly rebalancing after the close of trading on the third Friday of each month. Any eligible spin-off occurring at least seven business days prior to the rebalancing date is included in the Index at the monthly rebalancing.

4. A constituent security that has been included in the Index for more than 48 months is removed at the subsequent monthly rebalancing; however, if the deletion of a constituent security would result in the number of constituent securities of the Index being less than 20, the deletion will be delayed until the next monthly rebalancing where the resulting number of constituent securities would be at least 20.

This methodology results in 64 current holdings. Here’s a sampling of top companies that pass the test:

Source: Guggenheim Investments, CSD Holdings 1/4/17

...In the end, you can profit by investing in the stocks that most investors don’t want. Spin-off investing has proven to be a time-tested, unconventional strategy that beats the market.