A Winning Stock Strategy: Sell on the Rumor

The surest way to profit from takeover speculation in the stock market is to bet it's wrong.

Bloomberg examined 1,875 rumors about pending buyouts of 717 companies from 2005 to 2010 and found a total of 104 of those companies were acquired. While stocks that were the subject of takeover speculation initially jumped, they tended to decline over ensuing weeks. An investor who sold such stocks short—selling borrowed shares in hopes of buying them back at a lower price later—would have earned average profits of 1.2 percent over the next month, an annualized gain of 14 percent.

It's a strategy John S. Orrico has used. "We see it as an opportunity to sell if we think the rumor is false or ridiculous, which in most cases" it is, says Orrico, who focuses on mergers and acquisitions at New York-based Water Island Capital, which oversees about $2.2 billion.

Opportunities to employ the strategy are increasing as the stock market climbs and merger activity picks up. The number of unconfirmed stories about possible mergers surged to 611 last year, a 71 percent increase from 2009, data compiled by Bloomberg from more than 50 news providers and brokerages show.

Stocks tracked by Bloomberg gained 2.9 percent on the day they were mentioned in a takeover story. They fell 0.2 percent, 0.6 percent, and 1.2 percent, on average, in the day, week, and month following a reported rumor. The Standard & Poor's 500-stock index rose 0.03 percent, 0.2 percent, and 0.5 percent, on average, during the same periods. That makes sense to Todd Salamone, an equity analyst at Schaeffer's Investment Research in Cincinnati, who says that by the time market chatter is publicly reported, it's been passed around trading desks via instant messages and e-mail and is usually old news. While "the rumors tend to create a pop," he says, "it's a very short-term event."

Akamai Technologies (AKAM) has been the subject of more buyout rumors than any other U.S. company since the beginning of 2005, Bloomberg research found. The provider of computing services that speed delivery of Internet content remains independent after being named 21 times. The most recent instance was Dec. 16. After rallying 1.7 percent when the speculation was reported, shares of the Cambridge (Mass.) company lost 3.8 percent in the next week, while the S&P 500 gained 1.1 percent. Spokesmen for all the companies in this story mentioned as takeover targets either declined to comment or did not respond to requests for comment.

NetList (NLST), a computer memory systems maker, rose 1.9 percent, to $5.52, when rumors were reported on Dec. 28, 2009 that Microsoft (MSFT) might buy it. The shares declined 2.2 percent a day later, 9.4 percent a week later, and 31 percent in 30 days. "NetList makes memory modules that go into servers, so Microsoft is not the type of company that would want to go and buy them," says Richard Kugele, an equity analyst at Needham & Co. "There's a difference between hardware companies and software companies, and it's just completely outside the bounds of what they do."

Even when they coincide with other bullish signals, rumors usually don't prove accurate. The volume of call options in Jefferies Group (JEF)—giving the holder the right to purchase the stock at a certain price—jumped amid unconfirmed takeover reports on Feb. 27, 2008. A deal never occurred, and Jefferies stock plummeted 3.4 percent the next day and 10 percent the next week. It had fallen a total of 20 percent 30 days later.

Some stocks are acquired after years of speculation. OSI Pharmaceuticals (OSIP) was the subject of takeover talk nine times from 2005 to 2009, and the shares slipped on eight of those occasions. The stock jumped 52 percent on Mar. 1, 2010, the day Tokyo-based Astellas Pharma said it would begin a hostile offer. There's no record of any takeover rumors in the days leading up to the announcement. Astellas bought OSI on June 9.

Many rumors are losers from the start. MetroPCS Communications (PCS), the wireless network, lost 1 percent on Sept. 21, 2009, after a news service reported chatter about a potential bid. The stock fell 34 percent over the next month and 49 percent for all of 2009, when the shares posted the fourth-biggest retreat in the S&P 500.

"The question that remains unanswered is: Where does the takeover story originate?" says Michael McCarty, managing partner at Differential Research in Austin, Tex. "It's most likely from someone who's interested in selling." Deliberately spreading false rumors may violate securities laws, especially if the intent is to sway prices, says James D. Cox, a professor at Duke University School of Law. Proving a market manipulation case is difficult, according to Peter J. Henning, a law professor at Wayne State University and a former federal prosecutor. "You might be able to see a unicorn before you see a market manipulation case established based on rumors," he says, adding that it is difficult to prove that someone started a rumor and then traded on it. "You get lots of investigations announced and very few cases brought," he says.

Overall, Bloomberg found that companies mentioned in takeover rumors were no more likely to be acquired than any other company. The safest strategy might be to avoid investing on gossip entirely. "Don't chase rumor stocks," says Michael Vogelzang, chief investment officer at Boston Advisors. "You never know where you are in the chain, whether you're the first to hear it or the last. You're just playing with fire."

The bottom line: Stocks that are the subject of takeover rumors jump, then fall, making short sales a winning strategy. Ignoring rumors works, too.

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