(MONEY Magazine) – Pitney Bowes' decision last December to spin off its office services business as a new company called Imagistics International seemed like an obvious way to dump a dog of a division. Earnings at the unit--which rents, sells and services fax machines and copiers--had slipped for three years straight, and growth prospects didn't look promising. The new stock lost a quarter of its value in its first week of trading. Since then, however, Imagistics has staged a turnaround. By adding new products, focusing on high-paying clients and cutting costs, the company boosted its earnings 25% in the second quarter of 2002, compared with the same period the previous year. Shares of Imagistics are now up 50% since the spin-off.

SPINNING STRAW INTO GOLD But the Imagistics story isn't unique. While we assume anything that's discarded is inherently bad or doesn't work, many spun-off companies improve once on their own. Consider: Of the 26 companies cut loose from their parents last year, more than half are outpacing Standard & Poor's 500-stock index, and several of them have posted truly stellar gains. Coach, the designer bag maker, has risen 90% since being cast free from Sara Lee in April 2001, while credit- and debit-card processor Global Payments has soared 80% since its February 2001 spin-off from NDCHealth. Research suggests that such performance is no fluke. According to a study by McKinsey & Co., which looked at more than 300 spin-offs between January 1988 and September 1998, the average return for a spin-off in the first two years of trading was 27%, compared with 17% for the S&P 500. These results jibe with an earlier study by James Miles and J. Randall Woolridge at Penn State University reporting that spin-offs between 1965 and 1994 recorded an average 76% return for their first three years of trading, beating the overall market by 31 percentage points.

What explains such performance? For starters, being spun off tends to reinvigorate management. "The entrepreneurial zeal is revved up because they go from being the red-headed stepchildren to actually running the show," says Joseph Cornell, president of Spin-Off Advisors, a research and hedge fund management firm. Managers also gain direct access to the capital markets to grow their businesses as they see fit.

On top of that, spin-offs are often initially undervalued simply because many investors who own the parent company dump their shares of the newly independent company on the grounds that it doesn't fit their diversification strategy or investment discipline. Similarly, index funds often retain the parent but sell the spin-off. John Keeley, manager of Keeley Small Cap Value, which has 45% of its assets in spin-offs, says early selling pressure makes many new spin-offs undervalued by as much as 20%.

BUT DON'T FALL FOR A SPIN JOB Of course, blindly investing in spin-offs is no secret formula for market-beating returns. Plenty really are dogs, so research them as thoroughly as you would any other investment. Type in the proposed spin-off's name in the Securities and Exchange Commission's EDGAR database (www.sec.gov) to find its form 10-12b, which breaks out the new company's financials for the past five years. One deal Spin-Off Advisors' Cornell has been watching is Citigroup's late-August spin-off of its Travelers property/casualty business. In mid-August, he predicted that Travelers had a 50% chance of not being included in the S&P 500, which he expected would result in the dumping of 60 million additional shares. At that time, the portion of the company already public traded at 11.4 times estimated 2002 earnings, a discount to rival Allstate's 13.6. And with demand for insurance increasing following last year's terrorist attacks, Travelers should benefit from higher pricing over the next few years.

--Jeff Nash