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Strategies & Market Trends : Speculating in Takeover Targets
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From: richardred8/29/2010 11:37:59 PM
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How To Profit From Mergers And Acquisitions

Holding shares in an acquisition target provides the most upside, as shareholders of Potash Corp. of Saskatchewan can attest.

By | 30.08.2010

Between the time that a merger is announced and when it is completed, there is often a difference between the merger price and the actual price that the company being acquired is trading at. This difference is an allowance for the risk that the merger will not be completed under the proposed terms.

As a simplistic example, let’s say Company A offers to acquire Company B. The terms of the deal will give shareholders of Company B one share in Company A for each share of Company B they currently hold. Shares of Company A are trading at $20 and shares of Company B are trading at $19. To realize this 5% profit, you would short shares of Company A at $20 per share and buy an equal amount of shares of Company B at $19 per share. Both transactions are necessary because you want to lock in the price differential between the two stocks. If you only buy Company B and the price of Company A falls to $19, you will not earn any profit.

The danger with this strategy is that the merger may not be completed. As a result, the scenario offers only a small reward, but big downside risk.

Investment banking companies, such as Goldman Sachs (GS) and Morgan Stanley (MS), profit by collecting fees from M&As. They are not “pure plays,” however, since their profitability also depends on other lines of business such as bond offerings, trading and wealth management. Thus, it is difficult to make an investment case for these firms simply because M&A activity has increased.

Holding shares in an acquisition target provides the most upside, as shareholders of Potash Corp. of Saskatchewan (POT:US) can attest. Literally overnight, the value of this stock skyrocketed. Unfortunately, it is impossible to predict which companies will actually become a merger target without insider information.

What you can do as a shareholder is look at industries where mergers are occurring and evaluate if there are any good investment opportunities in them. The key is to find stocks that would be good investments even if no acquisition offer were ever made; simply investing on the hopes of a merger is pure speculation. Secondarily, you want to evaluate the competition to assess if there is a potential buyer for the company.

A potential buyer has to have the size, financial means and desire to acquire the subject company. For instance, though Potash Corp. is tied to the global agriculture market, it has a limited number of potential buyers. The reason is that its market capitalization is large (currently in excess of $40 billion, thanks to the merger premium) and it operates mines. Thus, a would-be buyer would need to be big enough and have a reason to be involved in the mining business.

Keep in mind that if even there are potential buyers for a company you are invested in, there is never a guarantee that an offer will ever be made. If an offer is made, you will need to evaluate the acquiring company to determine if it makes sense to follow the merger to completion. Each deal is different: You will have to weigh the benefits of maintaining your investment against both the potential risks of the merger not being completed and the opportunity costs of not investing in another company.
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