Post Take-Over Announcement Plays

One of the holy grails in trading is to find companies that may be potential take-over targets because if one can correctly identify them, the rewards can be considerable. A take-over announcement can boost the acquiree's stock price by 10%-50%, although share increases in the 10%-25% range are usually the norm. That's nice work if you can get it, but it's in the getting them where lies the rub. Factors that go into trying to figure out what companies are ripe for the picking include low price to book value, companies in sectors that are undergoing consolidation, and technical factors such as unusual options volume which can be a sign that people are trading on inside information. (It's illegal but it's done every day.)

Correctly identifying a potential take-over candidate can be very time-consuming and ultimately unrewarding. More often than not you will be wrong which could wind up costing you a lot of money on many failed speculations. But I got to thinking, what about playing stocks after the take-over has been announced? Can one make any decent money on them, or will it only amount to chump change?

To test out my hypothesis, I looked at 62 companies that announced they were being taken-over between March through July of last year. I set up my simulation to buy each stock at the closing price of the day the take-over was announced. Then I checked the date the stock was acquired and the price at which it was sold. The results actually surprised me. Before I present them, I have to say that the data is based on 57 companies. Those are the ones where the acquisition was completed. In two instances, the deals fell through completely. In one case, the merger was extended and is still pending. In the last two cases, the mergers are still pending but are on shaky ground because of regulatory hurdles in one and a reduced financial outlook in the other.

So, without further ado, here's what I found:

1. The average time for a merger to complete (from announcement to the final take-over date) was about 4 months with a standard deviation of around 2 1/2 months. This means that 68% of most mergers occur between 1 1/2 and 5 1/2 months. (For you statistical wonks out there, the median was around 3 months.)
2. The average gain/loss per stock was +2.9% over the holding period. This result assumes that an equal number of shares of each stock were purchased at the closing price on the day of the take-over announcement. (This value would be different if an equal dollar amount were bought.) The standard deviation of the gain/loss was 2.75% which means that two-thirds of the stocks ended up gaining between 0.15% and 5.65%. There was one stock that gained 17% because the original offer price was subsequently raised. Two stocks actually lost value. One was due to a merger battle, and I couldn't find a reason for the other.
3. If we assume that the average holding time for each stock is four months, then this results in an average annual return of 8.7% (2.9% x 3).

You may yawn at an 8.7% return, but basically this is done without incurring a lot of risk. So far, only two of the proposed mergers have fallen through, which is a 3% failure rate. Not bad. There aren't many portfolios out there that can boast a number even close to being that low. A major drawback to this strategy is that M&A activity is at the mercy of the markets. This means that during down markets such as now and especially during the current credit crisis, M&A activity is reduced. During bull markets, this certainly isn't the best strategy to use to increase your returns, but it's still not a bad one especially for those of you who are highly risk averse.

Final Note: The above data was derived from the closing prices, but if you pounce on these at the open, you can probably do a bit better. Hey, that's not a bad idea. For tomorrow, I'll look into this further and see if there's a measurable difference in the rate of return between using the opening price and the closing price, so stick around!