Where to Begin
When thinking about making new investments you may feel like you're looking at a barren wasteland filled with landmines or a fertile plain filled with opportunity. The point is that, at first blush, many investments look quite similar. You know that some will turn out badly and some will turn out well; the trouble is identifying the ones which offer the best chance for success.
You could go to your broker and ask for their research and begin looking at some of their "buy" recommendations. This is probably not the best course of action. These reports are called "sell side" research for a reason. You wouldn't blindly trust a used car salesman to point you in the right direction for your next car, right?
So where do you begin when looking at new investments? The most fruitful beginning is to look for opportunities which are undervalued for a bad reason. There must be a hook that convinces us that folks are wrongly selling their stakes.
THE DEFINITIVE LIST OF REASONS TO INVESTIGATE A STOCK
...doesn't exist, so we have to make do with an imperfect set of "hooks". Our first goal when investigating new opportunities is to identify changes in a company that cause current owners to want to sell this stock. These reasons are typically intimidating to an investor: bankruptcy & restructuring, major mergers & acquisitions, license & contractual arrangements, and spin-offs, among others. These are situations in which what you own before the event is different from what you own after the event. Such events often cause investors to sell regardless of price. This is what creates our opportunity.
For now, we'll focus on one of these hooks: spin-offs.
Spin-offs occur when a company wants to ditch part of its business that no longer fits with its strategy or is just too different from the rest of its business for management to manage. There's no IPO, the company simply sends new shares of the orphan business to its shareholders. One day shareholders own one stock and the next they own two separate stocks.
Not all shareholders are going to want both of these stocks. After all, the company itself didn't want to own the orphan. This is part of the opportunity: some shareholders will sell these new shares without much thought to price. The new company has no independent track record and the sell-side hasn't had the chance to publish their "buy" reports yet. Motivated sellers. Few buyers. If these influences cause the price of the new company to decline enough, this is a good time to swoop in and pick up the shares at a bargain.
REVVING THE MOTOR
In 2010, Motorola (MOT) announced that it would spin-off its languishing cell phone business from its stable radio and communications business. MOT's cell phones were an afterthought in the marketplace against the wildly successful iPhone and the business had fundamentally changed in the few years since MOT's last successful consumer phone, the (pre-smartphone) RAZR.
So, the company split into Motorola Solutions (MSI), its radio and communications business, and Motorola Mobility (MMI), its cell phone business. MMI debuted around $25 per share in the 2011 spring. After a brief bump, the market decided "why would we want a stock that competes with Apple?" and drove the price down to $20 in July.
And that is where it became interesting. MMI was a late-comer to the smartphone market and had decided to adopt Google's Android software to run on its phones rather than develop its own software (it's a hardware company, after all). Meanwhile, Google had recently lost an auction for hardware patents from Nortel, a bankrupt telecom, to Apple, Microsoft and others. Eager to build its hardware technology patent holdings to keep pace with Apple and Microsoft, Google rode in and bid $40 for MMI, double its July price.
After MOT's spin-off, the market saw MMI as a fading contender unable to compete with the likes of Apple and sold shares cheaply. Google (and some savvy investors) saw a stock with a massive collection of valuable technology patents and top-notch engineering in a highly competitive marketplace.
THE RIGHT HOOK
Although its not a good bet that Google will ride in and rescue all the cast-offs of other companies, you, as the astute investor, should be creative when evaluating those hand-me-downs. While they may not be important to their former parent, they often are still valuable. For the investor, it comes down to a matter of price: is the price of this orphan justified or is the price of this orphan low just because its an orphan? In the case of MMI, the spin-off was a great opportunity for investors to win a quick, low-risk return.