What
is a tracking stock?
Companies offer tracking shares to permit valuation
of a specific piece of their business. The parent company's original shares are
reclassified to reflect the performance of the rest of the business. In theory,
the parent company does this to demonstrate that the two parts (parent and tracking)
added together will reflect the true value of the company and be worth more than
just the original shares before the tracking shares are created. Unlike common
stocks, tracking shares don't always represent ownership interest in the underlying
company, and many times the holders of the shares are not privy to many of the
voting rights and protections given to shareholders of the parent company.
Why are tracking stocks enjoying
popularity?
They are popular with both companies and investors because
they let the market judge the worth of a fast-growing segment of a company independently
of its other lines of business. However, not everybody likes the concept of tracking
stocks. Because the cash flow of the reclassified parent can be used to pay the
liabilities of the business line being tracked (and vice versa), there may be
a temptation for companies to practice accounting manipulations and obscure the
real worth of the individual business lines.
Advantages of tracking stock
to company?
Some companies can raise capital more cheaply with a
tracking stock. A company having difficulty raising capital might positively influence
potential investors by using a tracking stock to demonstrate how the economic
entity would look as a stand-alone company. This permits the investor to better
see how his/her funds are being used. In addition, tracking shares are sometimes
used as "currency" for acquisition. They tend to be pricier because investors
are willing to pay more for the growth usually inherent in these stocks. There
are numerous advantages to using a tracking stock instead of spinning off a business
line to be its own company. First, losses incurred by the business line covered
by the tracking stock can be applied to reduce taxes owed by the parent company.
This would not be the case if the business line was spun off as a new company.
Second, raising money from investors is generally easier because tracking stocks
are still owned by a larger company with a stronger financial position (i.e. deep
pockets). Typically, a spin-off would have to pay more for its capital because
it would be smaller and on its own.
Are tracking stocks good
investments for shareholders?
In
recent years, tracking stocks have not lived up to their "hype" and have lagged
the performance of their peers and the market overall. A couple of reasons which
may help explain why tracking stock performance has tended to lag: 1) shareholders
will not receive the big premiums that usually accompany corporate takeovers,
and 2) there may be a conflict of interest for company directors and shareholders
in a possible acquisition of a company that provides similar products and/or services.
Our Recommendation
Like other financial investments, a tracking stock should be evaluated based
on its own merits (e.g. growth, profitability, risk, etc.), not as an investment
class. Normally, a tracking stock will not meet our strict investment criteria.
For further explanation and
illustration on tracking stocks, click
here.
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