Mergers Are Hot. You Should Stay Cool.
When companies get hitched, CEOs get rich. What about you? Follow these rules of marriage.
(MONEY Magazine) – SBC proposes to AT&T for $16 billion. Gillette says "I do" to Procter & Gamble for a dowry of $54 billion in P&G shares. This year is off to a fast start for mergers and acquisitions, after 2004 set a near record, with corporate weddings totaling more than $800 billion. That's all good for the fat cats at merging companies, who get jumbo pay hikes and huge ego boosts out of joining forces. It's good for Wall Street, which rejoices in investment banking fees whenever a pair of companies walk down the aisle. But is it good for you? Can you make money buying the stock of companies that tie the knot? And if you already own shares in a company that's being bought out--or in one that's doing the buying--what should you do?
Rather than advise you on how to respond to a particular merger in today's headlines, I'll try offering general rules to guide you no matter what kind of combination the market throws at you. You will still need to study the individual companies and circumstances, but these rules will help put the law of averages on your side.
Let's start with the fact that mergers force you to re-examine a stock you own or were thinking about buying. When a stock skyrockets on a merger bid, that rivets your attention. Gillette went up 12% in a matter of seconds after P&G announced its intentions. Don't let that short-term thrill blind you to the dismal long-term record of troubled marriages like AT&T/NCR, Hewlett-Packard/Compaq and AOL/Time Warner. Scholarly research confirms what investment bankers have always known but have kept a trade secret: Targets (the firms that are acquired) do get a short-term boost in return. But acquirers (the companies that do the buying) tend to lag the market for three to five years after a major deal. It was true as far back as the 1920s; it remains true today.
Rule 1 DON'T RUSH IN TO BUY
If you don't already own shares in the firms involved in a merger, stay away. By the time you buy, the target stock will already have jumped. The acquirers either underperform or don't return enough to compensate you for trading costs and the havoc you wreak on your asset-allocation scheme when you're always chasing head- lines. And by all means avoid the most common type of deal--a "friendly" one in which the target agrees to be bought out with shares of the acquirer's stock. Those tend to be the biggest dogs.
Rule 2 HOSTILE TAKEOVERS CAN BE FRIENDLY TO SHAREHOLDERS
Accounting professor Derek Oler of Indiana University has shown that, on average, only the kind of merger known as a hostile takeover creates positive returns--for up to five years running. Many targets of unsolicited bids have been struggling for years under en- trenched management, making them ripe for a recovery. If you own a stock on either side of a hostile bid, you should vote your proxy in favor of the deal.
Rule 3 STEER CLEAR OF "SERIAL ACQUIRERS"
Companies that compulsively take over other companies by the dozen run into problems down the road. Years later, Tyco hasn't fully recovered from its buying binge of the late 1990s. Nor has Cisco, which gobbled up plenty of tech companies during the bubble era.
Rule 4 STAY AWAY FROM STOCK DEALS IN A TRENDY SECTOR
See Cisco, above. Here's a more dramatic example: In May 2000, Lucent paid $4.5 billion in stock for Chromatis, an optical networking start-up with only a handful of customers and almost no revenue. Just 15 months later, Lucent wrote the whole thing off as a loss while its own stock tumbled.
If you own a company in a hot industry that's bought out for stock, it's a good idea to diversify the proceeds to limit your risk. You wouldn't want to end up buying the next Lucent at the top, would you? That's especially true if you own the shares in a retirement account, where you can move your buyout proceeds without incurring a current tax bill.
Rule 5 FAVOR CASH DEALS
Accounting professor Henock Louis of Penn State University has shown that companies using shares of their own stock to finance an acquisition underperform similar-size firms by a cumulative 17.5 percentage points over the following three years. Companies that use cash as the acquisition currency, however, outperform by 16.3 points over the next three years. Part of the explanation is that more often than not, hostile bidders use cash (see rule 2). In addition, Louis warns, stock acquirers are more likely than cash buyers to engage in "earnings management"--the kind of accounting gimmickry that raises a stock's return in the short run but comes back to haunt investors in the long run. So if you own a stock on either side of a cash deal, you should probably hold. And that leads to...
Rule 6 TOO MUCH CASH CAN BE TRASH
If at least 15% of an acquirer's total assets are in cash or cash equivalents, but it nevertheless uses stock to buy another company, that's a red flag. In such cases, warns Indiana's Derek Oler, "the excess cash is not used up and is therefore available to be wasted on other perks." (Next thing you know, the CEO might install a $6,000 shower curtain.) Cash-rich firms that use stock for friendly mergers with other companies, Oler finds, drastically underperform during a five-year period. This kind of deal signals that you need to scour the proxy statement for signs of overpaid and overperked bosses. If you don't like what you see, consider selling.
Long ago, Benjamin Graham warned that he had "considerable doubt" that most mergers were "an aid to earning power." History, as usual, has proven Graham right. These deals have continued to disappoint investors and probably always will. If you already own a stock, a merger is a wake-up call telling you to keep a much closer eye on management. If you don't yet own a stock involved in a merger, there's no point joining the wedding party.