Plugging Into Merger Mania Without Burning Your FingersPam Black
Richard A. Freeman is a happy guy. When IBM grabbed Lotus, the 360,000 Lotus shares he owned as manager of Smith Barney Aggressive Growth soared from 29 to 62--for a more than $10 million profit. "It was a terrific morning," he says. You have to get lucky to be in on such a rich deal, but with merger mania heating up, your chances of profiting from corporate marriages are greater--and you can boost those odds. You can use a limited partnership or fund that does risk arbitrage. Or if you're a stock-picker, you can try to find likely takeover targets before they're bought. Both strategies sound highly risky, but you can take steps to make them safer.
After a heyday in the 1980s, takeover activity dropped in the early '90s. It has surged in the past two years, though, increasing 30% from 1993 to 1994. The action shows no sign of abating, as the June 19 bank megamerger of First Union and First Fidelity will attest. "Companies are much more efficient and ruthless, growth is slower, and it's just uneconomic to keep duplication out there," says Michael Metz, chief investment strategist at Oppenheimer & Co. The current round of mergers differs from the wild leveraged buyouts of the '80s. Most acquiring companies today buy for strategic reasons, to gain access to new markets, products, or economies of scale. And these are mostly friendly deals that are paid for with the stock of the acquiring company.
SMALL MARGINS. One way to play a wave of takeovers is with risk arbitrage. Arbitrageurs mostly buy into mergers after they have been announced. That way, they get the stock for a little less than the acquiring company will pay. If they do enough of these deals, they churn out a decent return. Unfortunately, most arbitrageurs are limited partnerships that require minimum investments in the millions. And in general, individuals can't do arbitrage because the small margins on arb deals would be eaten up by trading costs.
One mutual fund, the Merger Fund, allows the average Joe or Jane to participate with a minimum of $2,000. When it comes to arbitrage, most people think of risk. Surprisingly, though, the Merger Fund is the second-least-risky equity fund ranked by Morningstar Mutual Fund Performance Report. It has returned a fairly steady 10% a year since it started in 1989. That's partly because managers Bonnie Smith and Fred Green, like other arbs, remove market risk from mergers by selling short the stock of the acquiring company while buying stock in the takeover target. That way, if the acquirer's stock drops, which it commonly does during and after a merger, the fund has locked in its return.
Say A Corp., trading at $6 a share, buys B Corp., trading at $5, in a stock transaction. Merger buys B at $5 a share and will earn $1 when the merger is complete. By selling A short, however, or selling it at $6 a share, Merger locks in the $1 per share profit. However, it also sacrifices any windfall if A's stock rises. "You can't have it both ways," says Smith. "If you're trying to protect downside, you have to give up upside."
Merger Fund's managers only invest in deals that yield at least a 20% return on an annualized basis. For example, they bought Lotus at $61. IBM will pay $64 in cash. Merger makes $3 on the $61 investment, for a 4.9% return. If the deal gets done in two months as expected, that's 30% on an annualized basis.
WINDFALL PROFITS. "We talk to management of both companies, industry experts, Wall Street analysts, and competitors," says Smith. She tries to stick with friendly deals and to uncover possible derailments due to antitrust or other regulatory issues. "Most deals get done," says Smith. "Our job is to improve the odds even more."
The real windfall profits come from speculating or buying takeover targets before a deal is announced and the stock rises. This is always a bit of a crapshoot, but there are ways to better your odds. One is to look to industries that are consolidating, such as health care, banking, insurance, and defense. After talk of reform, health-care companies started consuming one another in response to pressure to control costs. "Large health-care companies need to be more efficient," says Charles LaLoggia, editor of Special Situation Report, a newsletter that identifies po-tential takeover targets. "One way to achieve economies of scale is by buying smaller companies." Hospitals, for example, are buying specialty-care businesses such as home health-care companies. So LaLoggia likes Ren Corp USA in Nashville, which runs a chain of dialysis centers.
If you don't have the time or money to invest in individual companies, you can buy into mutual funds that specialize in a consolidating industry. James Schmidt started John Hancock Regional Bank Fund purely as an industry consolidation play when the Supreme Court enabled states to deregulate interstate banking in 1985. At an average annual return of 20% a year, it's paying off. Back then, there were 14,000 U.S. commercial banks; now there are 10,500. Schmidt figures the industry will shrink to some 4,000 banks over the next 15 years and tries to buy those that will be bought out.
He looks for midsize ($30 billion in assets) and smaller banks that have strong market share, lots of core retail deposits, shareholder-oriented management, and sell at single-digit multiples to 1995 earnings. Some examples are Norwest, First Interstate, and Suntrust. He also likes S&Ls that have recently gone public: they are often cheap but cash-rich.
Other signs of possible targets occur when founding families or controlling shareholders have a reason to sell. Martin J. Whitman, manager of Third Avenue Value in New York, points to St. Joe Paper in Jacksonville, Fla. The Alfred I. DuPont Testamentary Trust, which owns 69% of St. Joe, needed a bigger dividend and forced the company to sell its paper business. On the news, St. Joe's stock rose 14% in March. One clue that a company is likely to go on the block: It announces that it wants to "maximize shareholder value."
Many deal-hunters look for a strong company with weak management. David Katz, chief investment officer at money manager Matrix Assets Advisors, bought gaming company Caesars World because it was selling at 30% to 40% below its industry average. "ITT saw they could leverage that asset better than Caesars' managers could," he says. "For ITT to enter that market, it would have had to spend a lot more. This way, they got a world-class brand name at a reasonable price." Katz bought Caesars' shares about a month before ITT and watched the stock climb more than 20 points.
Mergers are also likely where there are strong synergies between two companies. The Lotus takeover, for one, made lots of sense for both companies. IBM wants to bolster its presence in software and needs Lotus' Notes "groupware" program to compete with Microsoft Corp.'s Windows. Lotus, meanwhile, couldn't fight Microsoft on its own. The deal wasn't cheap, but it made business sense. "They're paying an obscene amount of money," says Katz. "But it would cost them billions to compete with Microsoft. So it was the lesser of evils."
Since you can never be sure a merger will strike, it's best to buy companies that you think will do well even if they aren't taken over. In short, you should adopt a strict value-investing style, buying companies with good balance sheets, management, and assets that are trading below their liquidation value. "We look for the same qualities an acquirer would seek, but we won't pay more than 50 cents on the dollar of what we think an acquirer would pay," says Third Avenue's Whitman. "We buy companies that will do O.K. whether they're bought or not." If you also get lucky and that company is dragged to the altar, you can anticipate many happy returns.
How to Play the Takeover Trend
Arbitrageurs, who invest in takeover targets after the merger is announced,
make money off the spread between the stock price then and when the deal is completed. Most require minimum investments in the millions, but the Merger Fund (800 343-8959) only asks for $2,000.
Riskier, but potentially more rewarding, is seeking out companies that might become takeover targets. Look at consolidating industries such as banking and health care. Other possibilities: companies with weak managements or niche companies that add synergy to a larger corporation.
Money managers who adhere to value investing often turn up takeover targets, usually cash- or asset-rich companies trading below their liquidation value. Value-oriented funds that seek out merger candidates include Third Avenue Value, Michael Price's Mutual Shares Series, Fairmont, and John Hancock Regional Bank.