How To Profit From Acquisition Rumors

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

On June 18, a strange thing happened to shares of Nokia (NYSE: NOK): they rose as high as 12% from their opening price, accompanied by exceptionally high volume. Soon enough, rumors broke out that Huawei, a leading telecommunication giant, is considering a buyout of Nokia. 

Twice in one month

This isn't the first time in June that shares of an alleged target company are skyrocketing. During the pre-market session on June 6, shares of SodaStream (NASDAQ: SODA) traded higher by 26% to a price over $87. The gains were in response to a report that PepsiCo (NYSE: PEP) was looking to buy the at-home soda maker. This marked the second day in a row that these rumors were being spread, although Wednesday it was Coca Cola looking to buy SodaStream. Apparently, the rumor mill has been working exceptionally hard lately.

The underlying rational

Almost all buyout rumors have some underlying logic. Nokia, for instance, is sitting on a bag of approximately 14,000 different patents. It only makes sense for Huawei to buy the whole company and integrate its patents into Huawei's new line of smartphones, rather than spend years in court fighting over them. At a cheap price-to-sales ratio of only 0.4x, it makes perfect sense to buy Nokia in its entirety.  In Pepsi's case, buying SodaStream will add a new business segment to Pepsi--the make-at-home segment. This way, PepsiCo can also benefit from customers who wish to prepare their own carbonated sugar water at home, rather then go out and buy themselves a bottle of soft drink. Contrary to Nokia, though, SodaStream isn't cheap. It's trading at a price-to-sales of 3x, and a price-to-earnings of 31x. 

From rumors to action

So, if an investor wishes to make money from an M&A activity, she must correctly time the M&A announcements and either purchase shares of the target company or sale short the shares of the acquiring company, right?

Well, not exactly. It turns out that this timing-task is on the verge of impossible. In addition, any attempt to purchase shares of the target company after the M&A rumors have become common knowledge has been proven to be a non-profitable strategy. As an illustration, anyone who bought SodaStream at the peak price of $87 is now sitting on losses of 16% in less than a week. These type of fast and furious losses are difficult to recuperate. But there is another way, a profitable one, to play M&A rumors.

How to look at rumors - the right way

According to research by Yuan Gao and Derek Oler on M&A rumors and pre-announcement trading, in most cases rumors fail to materialize into public announcements. It turns out that short selling rumored acquisition targets is, in fact, a profitable strategy.

The researchers further elaborate that on average, stock prices of rumored firms drift down to their pre-rumor level over a 70-day period after the initial price jump, and that only 12% of rumored takeovers materialize into actual announcements within 70 days. The average return to a shorting rumor strategy over this period is 4.2% (above index), and when one restricts this strategy to only include "hot" M&A years and exclude extremely large mega cap firms, profits increase to 12.7% (again, above index).

In other words, in 88% of the cases, rumors fail to materialize (due to a thousand different reasons), and the investors who were previously rushing to take a piece of the action are now rushing for the exit.

The explanation that the two researchers attribute to this phenomena is very clear--the market always overreacts to takeover rumors. Combining this psycho-financial fact together with the finding that 88% of the rumored takeovers never actually materialize leads to a profitable robust short - selling strategy.

The Foolish conclusion

There's no need to rush and try and buy shares of a rumored target company. In most cases, you'll make much more money by shorting the target company right after the rumor has already spread. It turns out that in most cases, well, rumors are nothing more than just rumors.

Nokia's been struggling in a world of Apple and Android smartphone dominance. However, the company has banked its future on its next generation of Windows smartphones. Motley Fool analyst Charly Travers has created a new premium report that digs into both the opportunities and risks facing Nokia to help investors decide if the company is a buy or sell. To get started, simply click here now.

Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends PepsiCo and SodaStream. The Motley Fool owns shares of PepsiCo and SodaStream. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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