Here’s the picture: The market has roared back, and you again hear buzz about a possible merger. So you call your broker and buy shares in one or both potential partners. Right?
Not so fast. True, the temptation to ride the flood of mergers–more than $760 billion this year–can seem irresistible. And many investors vividly remember those bidding wars of the 1980s; Stop & Shop’s stock, for example, more than doubled during one such contest.
And lengthy merger battles such as Hilton Hotels’ pursuit of ITT, can afford investors plenty of time to get in on the action.
But for the standard, uncontested merger, there is no lengthy contest.
And by the time the average investor has heard the news, the professionals have probably already squeezed the stocks for any short-term gains. The meager profits that remain “can easily be wiped out just in trading commissions,” warned Jay Kaplan, portfolio manager of the Prudential Small Company Value fund.
Moreover, the most ballyhooed deals can be derailed by the antitrust forces in Washington, as were the proposed mergers of Rite Aid and Revco, and of Office Depot and Staples. Or the stocks of both merger candidates can react unpredictably. Or the size of the offers and names of the players can change overnight.
On the surface, a focus on consolidating industries–betting on the stable rather than a single horse–seems a smart way to play mergers. During the banking merger mania of the 1990s, for example, some people have profited by snapping up bank stocks or the shares of mutual funds that specialize in banking.
But, especially for non-professionals, an industry’s fundamentals are more important than expected merger activity.
So is there any way an intrepid investor can make money from mergers?
Yes, many experts say. They advise average investors to play a long-term, after-the-fact game–buying into solid companies after the merger, when the combination seems likely to yield more than the sum of its parts.
Such a strategy will not provide the spectacular, speedy profits often generated during the initial talk about a big deal. But according to a recent study by CSC Index, a division of the Computer Sciences Corp., a consulting firm, the approach can substantially beat the market.
CSC evaluated 71 mergers–all those between 1989 and 1994 that were worth more than $500 million. It then isolated those that, from the year before the deals through three years after, saw their shares appreciate 5 percent to 15 percent faster per year than their peers’.
One notable example: In the merger of Chemical Bank and Manufacturers Hanover, the cumulative stock gain was 39 percent during the four years, while other bank stocks rose 22 percent.
The research company then took a close look at 18 of the 71 mergers–12 winners and 6 losers–to see if success could be predicted by the characteristics of the merger. It concluded that the winners had a detailed plan for integrating the merger partners and were clear about why they were doing the deal.
CSC says mergers come about for four reasons, only three of which seem to yield winning formulas. Successful mergers include these:
– Consolidations in which a dominant player folds smaller companies into its already finely tuned machine. That is what Nationsbank has done in financial services, CSC said.
– Pioneering mergers, in which two companies unite to enter a market neither was equipped to enter alone. When SmithKline Beckman and Beecham PLC merged in 1989, each was strong in some markets but unable to penetrate others. Together, they became the world’s fourth-largest pharmaceutical company, with tentacles on every continent.
– Talent-scout mergers, in which one company buys another to obtain access to its people, patents or processes. Cisco Systems, the hugely successful computer-networking firm, has grown largely by acquiring companies whose technologies fit niches that Cisco wanted to enter.
The fourth kind of merger involves what CSC called “revenue hunters”–companies that merge only to get bigger, without clearly thinking about how the two partners can benefit from each other.
According to CSC, Quaker Oats seemed to be merely seeking revenues when it bought Snapple. The merger never took, and the stock of the combined company underperformed other food companies by more than 30 percent.
Of course, investors should make sure the merged company has strong fundamentals, from its earnings growth to its market share. And the particulars of the merger should be examined for red flags.
For example, Dean McCauley, vice president of CSC Index, strongly suggests avoiding “novice acquirers”–companies that have not yet done at least four deals and may be unskilled at either pricing a transaction or assimilating a merger partner. And he suggests waiting at least a few quarters before investing in talent-scout deals.
“If key people start leaving after a quarter or two, that stock will drop fast,” he said.
Steven N. Kaplan, a professor of finance at the University of Chicago’s Graduate School of Business, would steer clear of any merger that is financed through stock swaps. “An acquiring company will not give out a lot of its shares unless it thinks they are already fully valued,” he warned.
If investors do follow a long-term, post-merger strategy, they may do particularly well because many of today’s deals seem very sound. In the 1960s, many mergers involved conglomerates like Textron or ITT buying up unrelated companies in order to hedge against economic cycles.
Wall Street hated this potpourri approach, and discounted the conglomerates’ stocks. Most of these companies have since sold off their disparate divisions.
In the 1980s, acquiring companies stuck closer to home, a notable example being Federated Department Stores, which snapped up many other retail chains. But many of the acquirers financed their deals through debt. And after the market crashed in 1987, many of those companies were unable to meet their debt payments without slashing staff and operating budgets, or selling assets at rock-bottom prices.
Today, prospective merger partners are almost always in similar businesses, and the deals are generally financed with stock or cash.
“Companies have learned to avoid the risks of poor strategy and overpayment,” McCauley said. “The early indications are that today’s deals will be more successful” than the ones in the 1980s.
But whether or not today’s deals make more sense, chasing possible merger candidates for short-term gains is still usually unwise.
As Steven M.H. Wallman, who served on the Securities and Exchange Commission until this past October, put it, “Individuals who try to invest in mergers are gambling, not investing.”
