NEW YORK (CNN/Money) - Takeovers and other corporate deals offer the potential for enormous profits. But these special situations are fundamentally different from other kinds of investments.
If you buy shares in a successful growth company, you may be able to hold them for a decade or longer, as long as earnings keep rising.
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By contrast, takeovers and other corporate deals are unique events -- where most of the profit occurs in a single burst. When it comes to capturing those one-time gains, individuals are at a decided disadvantage against professionals who almost always have better access to M&A information.
In a takeover, the acquiring company usually has to offer a premium of anywhere from 15 percent to 40 percent for the target company's stock. As soon as a bid is announced (and sometimes before, if there's a leak), the acquirer's stock typically drops, while the target's rises.
If you own stock in the acquirer, you have to decide whether you want to be a shareholder in the new firm. Merged companies may benefit from cost reductions and become more dominant in their markets.
But they often underperform comparable stocks for a year or more after a deal is completed because it always takes longer than expected to work out the kinks. So you should either get out at the first really good opportunity -- or be prepared to wait a while before seeing a significant payoff.
Recent bank mergers are a perfect case in point. Although they have solidified the dominant positions of leading U.S. institutions, the combinations have been slow to produce significant incremental earnings gains. As a result, the stocks continue to trade at below-average P/Es.
If you own shares in a target company, most of your potential gain will be reflected in the share price as soon as the bid is announced. It generally makes sense to sell quickly, because the chances of losing those windfall profits are greater than the little bit extra you could make by holding on.
There are situations, of course, where it makes sense to hang on through a merger. If you really believe in the combined companies' prospects, then go for it. Just be prepared to hold for at least three to five years if you have to.
And in deals where a company is acquired for stock rather than cash, holding on to the target helps you avoid capital gains taxes. You don't have to pay tax until you sell the new shares -- hopefully at a big profit.