Look before tracking stocks

In recent months, many major companies have issued tracking stocks.

But before jumping on the tracking-stock bandwagon, make sure you understand the potential risk and rewards, of this type of investment.

What are tracking stocks?

A tracking stock is issued by a parent company and is meant to reflect the performance of a particular division of that company. A tracking stock is issued separately to investors and is usually an effort by the parent company to increase shareholder value.

Tracking stocks are not the same as stock issued when a company spins off a portion of its business into a separate business. That's because the business represented by the tracking stock is still part of the parent company. Companies usually issue tracking stocks for their high-growth divisions.

How do tracking stocks benefit a company?

A tracking stock allows a company's board to align executives' compensation directly with their specific business units. The tracking stock may help illustrate the true performance of individual divisions of a company.

How can tracking stocks benefit investors?

Tracking stocks allow investors to buy shares in a portion of the business they are more interested in. Companies usually distribute shares of tracking stocks to current shareholders and may issue new shares to the public. Tracking stock shareholders are considered shareholders of the parent company and not of the division being tracked.

What are the risks in tracking stocks?

Not all tracking stocks allow their holders to vote on company matters. Some may provide rights that increase as the division grows in value compared to the parent company.

It is possible that conflicts of interest may arise between the tracking stock division and the parent company. The parent company may choose to compete with divisions or make deals with other companies in the same industry.

Investors should not expect tracking stocks to perform like parent company stocks. A tracking stock should trade in line with revenue growth for the particular unit. Since the tracking stock is still part of the parent company, any significant news affecting the parent company may affect the tracking stock.

Tracking stocks are not necessarily suitable for all investors. Some investors may have an investment personality and risk tolerance suitable for owning shares of the parent company and others for owning tracking stocks. Your financial consultant can help you determine whether investing in tracking stocks might make sense for your particular situation.

(Timothy M. Reese is vice president of investments with A.G. Edwards & Sons, member SIPC.)