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Spinoffs And Short-Selling

09/14/11 08:39:58 AM
by Billy Williams

Large companies break away nonperforming businesses into spinoffs while also burdening them with huge debts at the same time. However, for short-sellers, this represents the closest thing to a sure winner as they come.

Security:   LPR
Position:   Sell

As a company grows and develops, it also tends to move away from its original core strength by accumulating companies and projects in hopes of diversifying its sources of revenue. While this can help stabilize revenue, it can also create an organization weighed down by conflicting businesses and differing management teams arguing over which facet of the company should receive attention and resources for growth.

At times, companies may make the decision to rid themselves of smaller segments of their overall businesses by breaking the business away by conducting a "spinoff." A spinoff is a smaller subsidiary of the parent company that is taken public as a self-contained unit.

Now, there are plenty of reasons why a company might decide to separate itself from the fortunes of the business that is to be spun off, but for you, the investor or trader, the thing of significance is that spinoff represents several opportunities to make money by shorting the newly formed company. See Figure 1.

FIGURE 1: LPR. Frontier Oil spun off Lone Pine Resources in March 2011 to separate the parent company's Canadian oil and gas assets into its own self-contained unit. The newly formed company has been saddled with almost $289 million in debt, creating a bearish condition that a smart short-seller could exploit for a reliable profit.
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Sometimes a division of a company is such a dog that its parent company can't find a buyer at a reasonable price and management decides that if the unpopular business makes some money, then they will spin it off and take it public on its own. However, the parent company may also decide to load the new spinoff with debt that the parent company has accrued over time in order to free itself of the debt's burden and create shareholder value for its own stock.

Once the new company is taken public, it then has to cope surviving on its own in the marketplace while dealing with the burden of all that debt as well.

Add to that, most of the parent company's shareholders want little or nothing to do with the new company and the spinoff's share price plummets from a combination of neglect to outright abandonment. Soon, the word hits Wall Street and sellers begin to pile on the newly formed company and push its shares lower in price value.

For the skilled trader, this offers opportunities to ride the price lower as investors flee the stock and short-sellers begin to ride the downward momentum for a fast profit.

These stocks are simple to find. One of the best ways to follow the news for spinoffs is to go to Google Reader and put in the keyword "spinoff" and then select how many times a day you want to be notified of any news concerning spinoffs are reported. Once a company announces a spinoff, it takes an average of nine months before the company breaks away from its parent and begins trading on its own.

But by being aware that a new issue is coming out, it gives you an added advantage by tracking these announcements and then being prepared to ride their downward move.

Spinoffs are unpopular with the parent company's original investors and that is why the new shares that are issued are typically dumped for more established companies that have the allure of promising more stable returns than an unproven company burdened with debt and other hindrances. You, though, have the competitive advantage of not being trapped by waiting on the long side of a trade and can take advantage of a strong bearish trend as readily as a bullish trend, making spinoffs a fruitful playground for the intelligent speculator.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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