One of my favorite things about self-directed stock investing is finding under the radar, niche methods of locating companies for potential investment. Sometimes these little known stock selection edges can pay off handsomely for investors not afraid to try something new. I am particularly partial to niche-type strategies that have stood the test of time and have proven themselves in rigorous testing. 

Things are often not what they seem in the stock market with all the hubris, promotion and hype about certain investment strategies. This is why it’s crucial that every stock picking method be subjected to objective testing rather than simply relying on what everyone else is doing or saying. 

The stock picking tactic I’m about to tell show you has been extensively researched by everyone from JP Morgan to major universities. One study of 300 companies by research firm McKinsey & Company showed that businesses meeting this criteria beat the overall market by an average of 10 percentage points. That said, only about 30 companies per year meet the criteria for this stock selection method. In addition, not every company that meets the criteria is a smart investment. Sometimes there is simply too much debt involved. Other times a company just plain fails in the marketplace. However, as evidenced by numerous studies, this is a tried-and-true method for finding winning stocks. 

The method I am alluding to is spinoff investing. 

Although not completely unknown, it definitely falls within the less common stock-picking tactics. A spinoff happens when a public company jettisons, or spins-off, one of its divisions or subsidiaries to create another publically-traded company. What’s important to know is why investing in spinoffs makes sense. One of the underlying reasons cited is that when a business (in this case, the newly spun-off company) is allowed to operate outside of the corporate structure that originally developed it, entrepreneurial forces come into play: managers, no longer limited by arcane corporate polices, are able to spread their wings. (Not to mention the management’s possible stock options acting as motivation for greater productivity.) These things unlock the value inherent within the spun-off company. 

There are several ways to invest in spinoffs. The easiest is to purchase shares of the Guggenheim Spin-Off ETF (NYSE: CSD). This exchange-traded fund (ETF) boasts a three-year average return of 25.6% and is up 13.6% year to date. It follows the Beacon Spin-Off Index, comprised of spun-off companies. 

If you prefer to work a little harder in finding spinoff stocks, the SEC Edgar Online database is an essential source. Every company that wants to spin-off an existing business must file SEC Form 10-12b. By doing a search for this form on Edgar, you will discover all potential spinoffs for investment consideration. Watching the financial media for spinoff reports is another time-tested way of locating future spinoff investment targets. For example, News Corp. (Nasdaq: NWSA) is expected to split into two companies in the near future. In addition, giant food company Kraft (Nasdaq: KFT) has revealed its intentions to break off its internationally-focused brands into a new company named Mondelez. 

A few recently-completed spinoffs include L-3 Communications’ (NYSE: LLL) former technical services division Engility (NYSE: EGL), and shipping company Matson Inc. (NYSE: MATX), which separated from parent Alexander & Baldwin (NYSE: ALEX) earlier this month. And while these spinoffs have already happened, you might find that there is still opportunity with these stocks. Savvy investors would be wise to keep a close eye on these and other spinoff opportunities.

Risks to Consider: As stated above, not every spinoff is a winner. While the odds favor solid performance from spinoffs, sometimes it just isn’t the case. These failures can be due to a variety of factors such as too much debt or limited support in the spinoff’s early stages. Always remember to use stops and position size accordingly, even with the spinoff edge, as anything can happen.

Action to Take –> Practice finding companies ready to spin-off divisions by using the SEC Edgar database to search for SEC form 10-12b. This source can be a goldmine of potential and provide stock investors a solid edge in the market. Keep a close eye on the stocks listed above and watch the media for spinoff rumors — sometimes just the rumor will move the stock of the parent company before the spinoff is even announced.