Just tune into any of the business news media and you will often hear the term "special situations." When the market is hot, it's not uncommon to see newspaper and magazine articles, investment newsletters - even entire books - dedicated to the subject. 

And while the term sounds sexy, interesting and exciting - especially when accompanied by the phrase "fabulous profits," many investors don't really know what it means or how to participate. So, let's just take the mystery right out of special situations and look at how investors might actually profit from these unusual, but quite frequent events. 

Spin-offs occur when a company decides to separate a division and issues shares to existing shareholders. The company may either opt to completely spin 100% of the company off, or elect to retain a certain percentage of its shares, just issuing partial ownership to its shareholders. 

Spin-offs have recently made headlines, due to Altria (NYSE: MO) spinning off its Kraft Foods subsidiary on March 30. Most analysts believe Altria undertook this separation for two reasons: 1) to emphasize the value of its tobacco division, Philip Morris International. That company owns 54.3% - more than half - of global tobacco sales. Last quarter, its market share increased by 2%, especially internationally. It has a 43% share of the French market, and has barely tackled China, the land of great opportunity, and 2) to enable Kraft to better tackle its problems. 

There are plenty of reasons that companies - and investors - like spin-offs: 

• The spun-off company usually benefits because its management will now have a greater focus on its core business, especially as a good part of management's  compensation will be tied to its performance in the smaller company, instead of a larger, diversified parent in which it exercises little control.
• The smaller entity will most likely draw more attention from Wall Street, since a pure-play business is much easier to analyze and forecast.
• Often, the spun-off subsidiary will have a record of superlative growth, which investors will find attractive.
• Companies will often unload significant amounts of debt along with their spin-offs. That leverage - if handled properly - will often aid sales and earnings growth, which, in turn, will enable the spin-off to repay the debt.
• Parent companies may spin off a subsidiary so that the remaining company's actual value - previously buried among several divisions - will be realized by the market. This quite often occurs if the spin-off has been performing poorly.
• Parent companies may desire to rid themselves of regulation by spinning off their regulated subsidiaries.
• The spun-off division may begin life with a low market cap, unwanted by institutional investors due to various policy constraints, but very attractive to investors seeking a bargain.

But the number one reason why investors like spin-offs is the potential gain from appreciation of the new company's stock. Lehman Brothers' study of spin-offs from the top 1,500 U.S. stocks found that spin-offs beat the performance of the S&P 500 by an average of 18% from 1990 to 2005. 

This table shows the performance of recent spin-offs, which seem to be following suit: 

Of course, investing in spin-offs can be risky. The added leverage may not be a spur to growth, and instead, can become a noose around the company's neck. Additionally, without the support of its parent, a company may not stand well on its own. Consequently, it behooves investors to conduct their normal due diligence when investing in a spin-off. 

And if you desire some professional assistance in selecting potential winners, you might try the new spin-off ETF - Claymore/Clear Spin-Off ETF (AMEX: CSD). This ETF tracks 40 select spin-offs and has enjoyed a 16.7% return since it began trading in mid-December. The ETF requires that a company must be spun-off for at least six months before being included. Currently, its biggest holdings are Mosaic (NYSE: MOS), Discovery Holdings (Nasdaq: DISCA), and Expedia (Nasdaq: EXPE). 

Either way, spin-offs are one special situation that bears investigation. Next week, I'll discuss two additional paths to special situation profits: mergers and acquisitions, and stock splits.