What Every Investor Needs To Know About M&A

Active investors are always seeking catalysts that move stock prices.  Getting into a stock prior to a bullish catalyst hitting the shares is a sure way to earn big profits.

Price catalysts can include things like earnings releases, economic numbers, corporate announcements and a host of other happenings.

One thing is currently leading the pack as a catalyst that moves stock prices.  This thing is merger and acquisition activity or M & A for short.

2015 has been a record year for mergers and acquisitions (M&A).

Globally, M&A activity reached a volume of $4.9 trillion, beating the record of $4.6 trillion set in 2007, according to statistics from Dealogic.

merrill devil horns

M&A can be counted on to usually be a bullish catalyst for the stocks involved.

A few of the largest mergers of 2015 include the American pharmaceutical giant Pfizer and Irish counterpart Allergan announced a plan to merge late in November. The planned merger would be the second-largest M&A deal on record behind Vodafone AirTouch’s $172.0 billion acquisition of Mannesman in 1999.

In addition, U.S. broadband provider Charter  Communications announced plans to merge with Time Warner Cable.  This merger is valued at $79 billion.

Looking ahead into 2016, the M&A trend is continuing.

Pending monster sized deals include Dow Chemical agreeing to buy competitor DuPont in a $62.38 billion deal that will combine two chemicals companies that were founded in the 19th century. Both Dow and DuPont were pushed by activist investors to break up or find other ways to revitalize their businesses.

It is critical to note that not every M&A is successful.  Some fail miserably.  Here are a few examples over the last decades of failed M&A deals.

No biggest losers list would be complete without featuring the Sprint Nextel deal of 2005.  This $36 billion merger drove vast numbers of customers away sending stock plummeting nearly 50%.

sprint-merger

McClatchy’s buyout of the Knight Ridder newspaper group can also go into the annuals of M&A failures.  McClatchy paid over $4 billion for the group just as revenues from newspaper advertising went off a cliff in 2006 due to the internet.  McClatchy borrowed cash to to do the deal and now McClatchy is underperforming the Admarket 50 index by over 90 percentage points.

Finally, the avoided attempt by Prudential to buy AIG’s Asian insurance unit for nearly $36 billion is another large failed deal.  Fortunately, Prudential investors had the good sense to shoot the deal down at this insane valuation.

 

Why Do Companies Merge?

Understanding the reasoning behind M&A can help investors avoid the failures.

Companies merge and acquire other companies for a variety of reasons.  It can be anything from the vanity of a CEO who wants to own the competition to the creation of a genuine synergy.  However, several reasons for M&A activity stand out as being the prime reasons.

Taking advantage of each other’s strengths and weaknesses is a major reason why companies merge or acquire each other.  One firm may be very good at creating and manufacturing products but not so good at selling them.  This firm would be wise to merge with a company that is strong at selling similar products.  A merger of this type would create shareholder value.

Eliminating expenses and enhancing revenue is another prime reason for mergers.  Smaller companies often merge with larger firms for this reason.  A small company may not have the capital to pay the expenses needed to properly execute a money making strategy.  However, a larger firm would have the capital, gladly paying it to increase revenue.

Economies of scale are a key reason for mergers and acquisitions.  Often the larger company formed after the M or A transaction can purchase more raw material, employees and or inventory than either of the smaller separate companies pre-merger or buyout

These are but a few reasons companies undertake the often costly merger and acquisition process.  In general, the goal is to create shareholder and company value greater than the sum of the separate parts.

Many companies become growing stock companies due to an aggressive acquisition strategy.  This is due to the fact that its generally easier for a growing stock company to acquire other companies than to blaze its own trail.

Most investors don’t understand the steps required for a successful M&A activity.  Here are the 5 basic steps:

 

Step 1: Target screening

 

Companies first must define what they are seeking in a target.  This often includes creating a list of potential targets meeting the criteria to prevent wasting money and time by casting too wide a net. This step is often done in haste and that is often the reason that some mergers don’t gain traction.

 

Step 2: Due diligence

 

This drilling down into the financial and other details of the targets will further narrow the choices, Proper and complete due diligence can save companies a fortune and confirm the match makes sense.

due-diligence
Step 3: Execution

After the target has passed extensive due diligence, the transaction can be executed.  A smooth transaction execution happens when both firms are properly prepared and ready for the inevitable contingencies.

 

 Step 4: Integration. 

 

Integration can be difficult.  Meshing distinct cultures, structures, and values can take quite some time to smoothly merger the cultures. This final step is often overlooked in the zeal to merge.

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How To Profit From M & A

Merger arbitrage is a market neutral form of trading that seeks to exploit inefficiencies in the stock price of a company who has agreed to sell to another company for cash, stock, or a combination of both. By assuming the risk that a merger will not close, will close later than expected, or at a lower price than expected, an investor can generate returns greater than risk-free investments.  Because this type of arbitrage is not completely risk free, merger arbitrage is also known as risk arbitrage.

The simplest way to participate in merger arbitrage is to purchase shares in the Merger Investor Fund (MERFX).  This fund is ideal for those investors who wish to participate in the merger game in a passive manner.

The fund uses several time tested merger strategies to extract profits from the market.  The primary theory behind their investment philosophy is that takeover stocks generally trade at a discount to the deal price due to the time value of money.

This discount called the arbitrage spread reflects the deals anticipated timing and probability of success.  It is this spread the fund attempts to capture by putting on a long position in the target company shares following the deals announcement.

The managers are adamant that they NEVER invest in rumors or uncertain deals.   The position is held with the goal of selling at a profit after the deal closes.  In a stock for stock deal, the fund attempts to profit by going long the target and short the acquirer.  This method tries to lock in the spread.  MERFX has invested in thousands of mergers since inception and is very keen on risk management.  Their risk management philosophy involves correct position sizing, hedging and quantitative tools to rank opportunities.

An exciting potential M&A for 2016

 In my opinion, the most exciting M&A potential for 2016 is Canadian Pacific bidding for CSX Corp.  CSX has rebuffed Canadian Pacific’s $20 billion offer, but CP remains interested and may attempt a hostile takeover.  Investors need to keep a close eye on this situation!