Welcome back to Premium Income Investments! Hope you all had a wonderful week!
Today I want to talk about mergers and acquisitions.
I know, I know, I’m really late on the hype train here given that the acquisition of Twitter happened all the way back in October, but that’s not super relevant to me.
What I want to know is whether we can make money on mergers and acquisitions.
Obviously the investment banks and the companies acquiring or being acquired make money on these deals, but is there enough room for a retail investor to squeeze a few extra pennies as well?
Well, that’s what we’re going to find out today.
In the first seven months of 2022 there were more than 22,000 deals announced with a total value of over $1.73 Trillion dollars!
Now that’s a lot of money!
But according to Harvard Business School anywhere from 70-90% of these deals fall through.
On top of that, the realm of mergers and acquisitions is usually relegated to professional firms with experience in the arena.
This can be discouraging to hear, and might turn most investors off from looking into this strategy any further, but if we do a bit of digging, we’ll find that even the professionals don’t know what they’re doing.
Just take a look at this article from Kiplinger written all the way back in 2010. In it the author recommends that an investor should look at actively managed funds to get a slice of the action. But if we look at their specific recommendations, we can see that they have abysmal returns.
Two of the funds that this article recommended (MERFX, MNA) have had sub-3% returns for over a decade! So much for professional management…
Not only that, they also had lower risk adjusted returns than the benchmark S&P 500 index. Even if you had used leverage with these funds, you would have been worse off.
This is not to say that we necessarily can do any better, the point is that professional management in this arena means nada! Best case scenario, you make sub market average rate of return and pay a management fee for it.
Given that, what should we do?
Well, it’s not very clear what exactly MERFX strategy is when it comes to merger and acquisition based investments other than the purpose of the fund is to deliver returns superior to bonds but with less risk. The problem is, we are not really concerned with the bond market, we want an investment that has a similar risk and return profile to that of an equity investment.
The other problem with MERFX is that the position size is very small. For a specific strategy like merger and acquisition arbitrage it would be expected that the number of holdings would be smaller although the average quality would be higher. That is not what we see with MERFX given that their average position size is just under 2%.
After doing some digging around I stumbled upon this.
This is a formula put together by none other than Benjamin Graham himself.
In Graham’s mind, the best way to make money off of this setup would be to do some good old value investing analysis and then use the actual merger event to catalyze the profit. We would want to find a company with an intrinsic value higher than the current share price who is also about ready to be acquired. Preferably, this would also be a lesser known and low market cap merger which is less likely to have everything priced in already.
This looks very similar to what Graham would have called, “net-nets” a value investing method that discounted everything but the most valuable assets and then Graham would only consider it for purchase if this valuation was more than the current share price.
The sad part is that these for the most part have become less common over the years with the widespread availability of financial information, and those that do exist, have had their returns for the most part decimated. Similarly, it appears that this is how the merger and acquisition arbitrage has behaved as well. According to this paper the alpha generated from merger and acquisition arbitrage has also declined significantly through the 90s until today. While there may be alpha found here, I think it would require more digging than I have done here. This might be an interesting topic to return to in the future if I can develop some quantitative methods for testing different arbitrage strategies, but for now, I think this is a closed case.
But before we close, I’d highly recommend checking out InvestorSnippets. InvestorSnippets is a free daily newsletter which aggregates and summarizes a few important articles from big news outlets on stocks, ETFs, and markets. The newsletter can be digested in as little as two minutes if you read just the summaries, or if you want more information you can read the full article which is linked in the newsletter.
With that said, that wraps up today’s article! I hope you enjoyed it and have great week!
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