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Looking for value: When the child outperforms the parent

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When it comes to unlocking shareholder value, corporate boards, company management and activist investors often look toward spinning off a business that could stand on its own.

A complex company with many different operating units can be more difficult to manage than a company that's focused on a narrower range of businesses. So a business is carved out and sold to the public to stand on its own, in the hopes its value will be unlocked.

The parent company stock often gets an initial pop, but the challenge for investors becomes whether or not to stay invested or buy into a spin-off.

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Bespoke Investment Group co-founder Paul Hickey specializes in analyzing market data and has studied spinoff performance.

"Overall, the companies that are spun off are doing better than the companies getting rid of them," Hickey said. "The child does better than the parent."

He said investors who bought into the parent company may have a certain mandate and may not want to hold the more growth-oriented name of the spinoff.

"You tend to see weakness early on as people sell it, and they're not familiar with the company," he said. "After a couple of weeks, the child usually outperforms the parent by fairly wide margin."

The Beacon Spin-Off Index tracks the performance of spun-off companies. It's made up of companies that have been spun off from their parent companies in the previous 30 months and are traded on major U.S. exchanges like the NYSE or Nasdaq. Index members are assigned a modified weighting based on market value, and the index is updated every six months with new members.

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Julie Morris, a research analyst for Beacon Trust, has analyzed the performance of spinoffs and found that they historically tend to outperform their parent companies by about 22 percent in their first year. She pointed out that if you look at spinoffs' performance versus the broader market, the returns also are impressive. Beacon Trust, which owns the Spin-Off Index, is a subsidiary of The Provident Bank.

On average, those spinoffs also beat the S&P 500 by about 18 percent in their first two years as independent companies, Morris said.

For example, she pointed to oil and gas refiner Phillips 66, which was spun off from ConocoPhillips in May 2012. Since then, Phillips 66 shares have risen 74 percent. Meanwhile, ConocoPhillips shares have risen 17 percent. Other index constituents have had similar performance stories.

There are a number of reasons for the general outperformance, one being the more pointed focus on managing a simpler business. Sometimes, managers at spinoffs also have incentive compensation plans that are tied directly to company performance. That extra motivation could have a marked impact.

That's not to say that just blindly buying any spinoff will make money for investors. History has been littered with instances where those companies don't end up doing well. One such laggard is water technology company Xylem, which was spun off from ITT in October 2011. ITT shares have surged 124 percent since then; Xylem has fallen 9 percent in that same period.

However, since the inception of the index in 2006, the index overall has performed relatively well. It has outperformed the S&P 500 each year except 2008. There are risks associated with any kind of investing.

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Morris says that companies tend to sell off in the days after they've been spun off. That's when shareholders often sell their spinoff shares to raise cash.

And, if the spinoff isn't part of an index that its former parent company was, there could be selling pressure on those shares, too. The Beacon Spin-off Index accounts for this by not including a spinoff in the index until it has been a standalone company for six months. There's also an inherent risk when investing in spinoffs, as they don't have a track record of their own or a long trading history.

For those believing Morris' story about spin-off investing, there is an exchange-traded fund that tracks the performance of this index, the Guggenheim Spin-Off ETF, around since December 2006.

Morris said spun off companies are more difficult to understand and often trade at a discount.

She also said that because spin-offs don't get as much attention from analysts, there tend to be opportunities to find pricing discrepancies to capitalize on.

As with all investments, there are risks and investors should certainly consult their financial advisors, but spinoff investing could be an area to pay attention to, regardless of whether you're bullish or bearish on the thesis.

—By CNBC's Dominic Chu (Follow Dominic on Twitter: @TheDomino)

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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