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How to profit from a breakup

November 5, 2012: 9:58 AM ET

There's more than one way to cash in on corporate America's latest craze, the spinoff.

This article was published in the November issue of Money magazine.

By Paul R. La Monica

You'd think in a sluggish economy corporations sitting on mountains of cash would try to use some of that money to buy growth through acquisitions. Lately, though, the opposite has been taking place.

Kraft (KRFT) just completed the sale of its global snack business to the public through a spinoff. Other giants, like News Corp. (NWSA), Pfizer (PFE), and Safeway (SWY), have also announced plans to streamline by splintering off unwanted subsidiaries. Joe Cornell, president of research firm Spin-Off Advisors, says more than 80 companies have announced or completed splits since 2011 -- double the pace from 2009–10.

Why the rush to break up? In a slow-growing world, firms are racing to make their operations more efficient. Execs also realize that pure-play firms are more easily understood and are being rewarded with higher valuations, Cornell says.

So what's the smartest way to invest in this downsizing trend?

Think like a value investor

Go with the spinoff. Over long periods, beaten-down, under-appreciated stocks generally outpace the market, and what's more unloved than a business unit that gets kicked to the curb?

Once freed, "newly independent companies have more incentive to grow and more control over their capital," says John Carey, manager of the Pioneer Fund. No wonder spinoffs have risen 180% since March 2009, vs. 120% for the S&P.

Of course, there are risks: Many spinoffs start off as small enterprises, and some are jettisoned for good reason. You can reduce that risk by going with a diversified fund. The Guggenheim Spin-Off Index ETF (CSD), which invests in 24 small and midsize spinoffs, has beaten the S&P 500 by more than four percentage points a year over the past three years, mimicking a longer-term trend. Among this ETF's holdings are Cablevision (CVC) spin off Madison Square Garden (MSG) and ex-Expedia unit TripAdvisor (TRIP).

Play both sides

In some spinoffs, the sum of the parts is worth more than the whole, says Gerry Sparrow of Sparrow Capital Management. So it can pay to hold both parent and progeny. He owns McDonald's (MCD) and its former unit Chipotle Mexican Grill (CMG). Both have whipped the S&P 500 over the past five years.

Among upcoming spinoffs, Cornell likes McGraw-Hill (MHP), pushed by shareholders to split off its textbook business, McGraw-Hill Education. He thinks the move will allow the firm's financial-services information unit, which includes the Standard & Poor's rating agency, to be more focused. And Education becomes the second-biggest player in the textbook biz.

Pioneer's Carey owns Pfizer (PFE), which is splitting off its under-appreciated animal health unit. Zoetis, set to be the biggest veterinary drug company, saw its sales rise 18% last year. The move will allow Pfizer to focus all its energy on developing blockbuster human drugs. In other words: win-win.

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