Demergers - the hidden treasure

Mark Draper (GEM Capital) writes a monthly column for the Australian Financial Review.

This column was published in the month of August 2019 in the AFR.

There have been many Australian demergers in the last 15 years and well known US investor Joel Greenblatt says “there is only one reason to pay attention when they do; you can make a pile of money investing in spin offs”.

A spin off, created from a demerger, is the establishment of a separate independent company through the sale or distribution of new shares of an existing business or division of a company. Generally the reason behind demergers is the belief that the demerged company will be worth more as an independent entity rather than being part of a larger business.  

Unrelated businesses may be separated via a demerger so that the separate businesses can be better appreciated by the market. Sometimes the motivation for a demerger comes from the desire to separate out a ‘bad’ business so that an unfettered ‘good’ business can shine through to investors.  There are many other reasons why a company would pursue a demerger, but broadly the idea is to create the environment where 1+ 1 = more than 2.

Paint company Dulux is the poster child for the demerger Fan Club according to Matt Williams (Portfolio Manager Airlie Funds Management).  He quips he is the founder, president and treasurer of that club.   “The simple fact is that demergers have a higher probability than not, of adding considerable value. In 2010 Orica shareholders received one Dulux share for each share they owned in Orica. Dulux shares closed at $2.54 on its first day as a stand-alone company. Nearly 10 years later shareholders will receive $9.75 as giant Nippon Paints adds Dulux to its stable. The total shareholder return for Dulux over this period was more than 20% p.a.” said Williams.

Goldman Sachs analyst Matthew Ross in a research paper on the value of demergers showed that Australian ASX100 demerged entities on average have outperformed the market by 18.5% in the first year post demerger.

That same study found that one of the significant drivers of value for the shareholders in the companies involved in demergers, was that they typically increased the prospect of a takeover of either business.  Shareholders in demerged companies Dulux, Recall, Sydney Roads, and Rinker can attest to this assertion.  Demergers where the parent company still owns a stake such as Coles lessens this likelihood.

Williams said that “like all good things its pretty simple, demergers work because:

-      They allow good businesses previously trapped inside a conglomerate to be valued more precisely by investors.

-      Management can be properly incentivised and rewarded thereby driving positive outcomes and

-      Companies are able to be taken over, or if not at least a ‘control premium’ can start to be factored into the share price”

Investing in spin offs is not smooth sailing immediately following demergers however as quite often the spin off company is initially sold by investors.  This is because spin offs can often represent a small holding in the context of an investors’ portfolio and therefore sold as nuisance value.  Alternatively institutional investors sell as they are either not allowed to own stocks below a certain market size or they simply do not understand the new spun out business.  After the initial period when this wave of selling is done, an investment in a spin off can be lucrative.

Joel Greenblatt says that “both spin offs and merger securities are generally unwanted by those investors who receive them. Both spin offs and merger securities are usually sold without regard to the investment merit”.  This often results in the immediate performance of a spin off post demerger being poor.  He adds “as a result, both spin offs and merger securities can make you a lot of money.”

So enthusiastic about demergers is Greenblatt that he dedicates an entire chapter to the subject in his book “You can be a stock market genius”, which is well worth a read.

The next demerger that is proposed for Australian investors to consider is Woolworths spinning off their drinks division, good luck in the treasure hunt.