Investment legend Joel Greenblatt picked on the biggest, clumsiest opponents he could find.
As I showed you last week, he was an expert at taking on mutual funds and other overburdened institutional investors. And he made a killing: 50% per year over the 10 years he was in business.
And as my FDA Report readers could tell you, we've had huge success with strategies cadged from Greenblatt, who focused on "special situation" investing. In short, he bought stocks undergoing some sort of corporate reorganization – like mergers, acquisitions, and bankruptcy.
One of Greenblatt's favorite strategies was scooping up left-for-dead company spinoffs...
Corporate spinoffs occur when a company carves out a particular division to create a separate, stand-alone business. In most cases, the parent company gives its shareholders stock in the new spinoff.
Spinoffs create a dilemma for mutual fund managers. See, the new "daughter" companies are typically 10% to 20% of the size of the parent company. They almost always violate the size requirements of mutual funds holding shares of the parent. Managers must sell the shares with no regard to price or value.
Other times, mutual funds that track an index will dump spinoff shares because the new company is not included in the index.
Even better for us, smaller spinoffs don't often attract Wall Street analyst coverage. So brokers don't tell their clients buy them.
The combination of forced selling and little demand inevitably results in excess supply. That depresses the spinoff's initial stock price. Here's our opportunity. This temporary mispricing leads to huge profits for those who know how to play the game.
Penn State researchers, using 25 years of data, found spinoffs outperformed the S&P 500 by about 10% per year in the first three years as stand-alone businesses. Another study showed spinoffs crush the major indexes by 45% in the first two years of existence.
In You Can Be a Stock Market Genius, Greenblatt explained that when spinoffs occur, "pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and direct incentives take their natural course." In other words, new management is free to pursue its own goals, regardless the parent company's agenda.
Last year, 49 corporate spinoffs took place. In 2009, 31 new spinoffs have been announced. One easy way to hunt down these names is to browse the holdings in the Clear Spin-Off Index (CLRSO). It's comprised entirely of new spinoffs prior to their graduation from rookie status (about two years).
A tiny exchange-traded fund, the Claymore/Beacon Spin-Off fund (CSD) strives to track the index's performance. But I prefer to invest in the companies directly...
One name I'm watching closely is Care Fusion, a medical supply spinoff from giant drug distributor Cardinal Health. Cardinal will retain a 20% equity stake in the new company. On September 1, the remaining 80% will begin trading on the New York Stock Exchange under symbol "CFN."
As an independent company, Care Fusion will be able to find the right mix of research and development and sales focus for its medical supplies. And as the mutual funds dump shares hand over fist in early September, I bet you'll have a great chance to scoop up them up on the cheap.
Read more Stockhouse articles by Dr. George Huang