Doc's note: In today's issue, we're featuring an essay from my colleague and Extreme Value analyst Mike Barrett, in which he explains how an unusual plan can help you reap huge returns...
In 1920, two brothers set out to construct the world's first interconnected system of telephone lines.
Together, they founded International Telephone & Telegraph. The old phone company would eventually grow into one of the world's most renowned conglomerates of all time...
By the 1970s, it had morphed into a megacorporation called ITT, which ran a huge range of operations – including hotels (Sheraton), baked goods (Wonder Bread), and rental cars (Avis). At one point, ITT reportedly owned more than 2,000 individual business units.
Then, Rand V. Araskog took over the business in 1979 – and began charting a new course.
Today, we'll look at the surprising move he made. We're going to talk about spinoffs... and how they can help investors like us achieve incredible returns.
Araskog gradually shed some 250 businesses in order to shore up ITT's balance sheet, which had become heavily burdened with acquisition-related debt. His efforts culminated in 1995 with what the Los Angeles Times called "one of the most dramatic breakups in U.S. corporate history." ITT had decided to split into three independent companies, focused on insurance, manufacturing, and real estate, respectively.
What made Araskog's plan so unusual was the fact that one of the world's greatest conglomerates of all time was willingly breaking itself apart, for the benefit of shareholders.
Even competent corporate managers are only human. Most of them would rather manage larger companies than smaller ones.
But building empires can create waste and inefficiency. Breaking up empires through spinoffs can lead to improved efficiency and better incentives for corporate managers... as well as greater transparency and higher returns for investors.
In his classic, must-read book, You Can Be a Stock Market Genius, investor and author Joel Greenblatt lists five reasons that companies pursue spinoffs:
- Separating healthy, but unrelated, businesses so that the market can better appreciate each of them.
- Separating out a "bad" business so that an unfettered "good" business can show through to its investors.
- Getting value to shareholders for a business that can't be easily sold.
- Pursuing an alternative to an outright sale for the sake of tax considerations.
- Solving a strategic, antitrust, or regulatory issue, thus paving the way for other transactions or objectives.
Lastly, as prominent business consultant McKinsey says, "a business creates the most value for shareholders and the economy as a whole when it is owned by the best – or, at least, a better – owner."
That's exactly what Araskog's bold move with ITT accomplished. Looking beyond even his goal of deleveraging, the decision separated ITT into three independent, asset-rich businesses capable of attracting new owners (shareholders) and managers interested in each company's long-term success.
In 2011, the spun-off company that had retained the ITT name once again split itself into three public companies, spinning off its water-related infrastructure assets into Xylem (XYL), and its defense and aerospace assets into Exelis. Its highly engineered industrial lines remained part of the new, slimmed-down ITT.
Long-term ITT shareholders have reaped huge returns from these spinoffs as well...
- ITT Sheraton – Sold to Starwood Lodging two years after the 1995 separation at a 17% share-price premium
- Xylem (XYL) – Share price is up about 200% from the 2011 separation
- Exelis – Share price more than doubled when purchased by Harris in 2015
- New ITT – Since spinning off XYL and Exelis, ITT's share price has risen about 150%
We've had success with similar setups in my Extreme Value newsletter...
For example, in March 2008, we recommended Altria (MO) just before its spinoff of Philip Morris International (PM). Extreme Value readers made about 175% and more than 110% on MO and PM respectively, after we sold the stocks seven years later.
These are the kinds of outsized, triple-digit returns we want to see as investors over the long term.
It's tempting to believe that healthy companies should grow and grow, rolling up more businesses over time... But in fact, spinoffs can be hugely profitable. And as ITT's story shows, when spinoffs are good for the company, investors reap the benefits.
Doc's P.S.: In a recent issue of Extreme Value, Mike and Extreme Value editor Dan Ferris alerted readers to an ITT-like spinoff story with similar long-term upside... potentially as much as $520 for every $100 invested today over the next eight years. But you need to act fast... Dan believes huge multibagger returns will only be possible for those who get in at today's valuations. To learn more about Extreme Value – and how to access this recommendation – click here.