Shep Perkins, CFA, Chief Investment Officer, Equities, presents research and insights from Putnam’s equity team on market trends and opportunities.
This month’s authors: Gerard P. Sullivan and Arthur Yeager, Portfolio Managers, Putnam Multi-Cap Core Fund
A “special situation” could be the sign of a great investment opportunity. We’ve both been in the investment industry for over three decades, and we’ve gained insight on many ways to research stocks. Today, our investment process includes several types of idea generation, one of which is special situations. This refers to a variety of events that may drive performance in a stock. Often, it involves something unusual in the fundamentals of a business. A special situation could be a company exiting bankruptcy, a turnaround story, or a business that is restructuring or working out financial challenges. It could also be related to a seasonal event, such as tax-loss selling, or business initiatives such as initial public offerings. It can also involve complex — and therefore underfollowed — situations, such as SPACS (special purpose acquisition companies).
Typically, we pursue a special situation when we believe a company’s underlying business is worth far more than the value the market is currently placing on it. This has allowed us to seize opportunities when investors are slow to appreciate a company’s long-term potential. If we believe problems are temporary and fixable, and that the business has earnings power the market is meaningfully undervaluing, we take a position and wait for our thesis to play out.
Fishing in the spin-off waters
Among special situations, spin-offs can be compelling. Spin-off companies usually get less attention from investors because they are more difficult to research. Because they were part of a larger corporation, their financials may be distorted by intercompany accounting. Often, the business has been run less efficiently, as management’s attention was focused on other parts of the company. Spin-offs provide an opportunity for investors willing to work to better understand the fundamentals of the company.
Spin-off companies usually get less attention from investors because they are more difficult to research.
Spin-offs may outperform parents
According to analysis from Goldman Sachs as of 2020, the performance of spin-offs has generally been above average relative to that of the parent companies. Moreover, if the spin-off had a cheaper price-to-earnings (P/E) multiple, a lower growth rate, and lower margins than the parent, the spin-off had the potential to significantly outperform the parent. Taken as a whole, these variables would suggest that many of the spin-offs were undermanaged by the parent company. If the management of a spin-off company can improve growth rates and margins as an independent company, it is likely to drive the multiple and the stock price higher.
Looking at spin-offs versus the equal-weighted S&P 500 over the past 20 years also shows above-average performance when at least two of three attributes — cheaper P/E, lower growth rate, lower margins — were met. Although the percentage of outperformers and magnitude of the outperformance was not as high, we believe it still demonstrates the investment potential in spin-offs.
Examples from our research
Three examples of spin-offs from our research are Constellation Energy, Otis Elevator, and Universal Music Group.
Constellation Energy (CEG). This business was spun out of Exelon Corporation in early 2022. The company provides nuclear, hydro, wind, and solar power to more than 20 million homes and businesses. We believe CEG’s upside potential is much greater than its current stock price indicates, especially if nuclear subsidies continue to be implemented. Also, as more consumers place greater value on environmentally friendly energy sources, CEG, which positions itself as a “clean energy center,” offers further growth potential.
Otis Elevator (OTIS). In 2020, United Technologies announced the spin-off of this business, one of the pre-eminent providers of elevators and elevator servicing in the world. At the time of the spin-off, we believed the stock traded at a substantial discount to its closest competitors, and we established a position. Recently, the industry has faced some headwinds due to the slowdown in China’s property market, which accounts for only 20% of Otis’s revenues. In our view, what’s attractive is the recurring nature of Otis’s elevator service business, which remains an underappreciated asset.
Universal Music Group (UMG). In 2021, this company was spun out of Vivendi, a France-based integrated media and communications group. UMG is the owner of a vast and growing catalog of music content, and we believe it has a long and profitable runway to grow. Its growth potential is driven in large part by its ability to license its content to rapidly growing streaming providers such as Spotify and Apple Music.
We continue to dig deep in our research, looking for opportunities other investors may miss, particularly with special situations that are more difficult to analyze.
The views and opinions expressed are those of the author, are subject to change with market conditions, and are not meant as investment advice.
Putnam Multi-Cap Core Fund holdings as of 12/31/21: Otis Worldwide (0.97%); Universal Music Group (0.155%). Constellation Energy was not held.
Our investment techniques, analyses, and judgments may not produce the outcome we intend. The investments we select for the fund may not perform as well as other securities that we do not select for the fund. We, or the fund's other service providers, may experience disruptions or operating errors that could have a negative effect on the fund. You can lose money by investing in the fund.