An Investing Legend Predicts A Major M&A Boom -- Here's How To Profit

By StreetAuthority | Updated August 11, 2014 AAA

Some high-profile buyout deals have been falling apart lately.

For instance, the third largest U.S. wireless carrier Sprint (NYSE:S) just announced it would end its bid to acquire rival T-Mobile (NYSE:TMUS), the number four carrier, because of staunch resistance from regulators. Media giant 21st Century Fox (NYSE:FOXA) ceased its pursuit of Time Warner Cable (NYSE:TWC) because the two simply couldn't agree on a buyout price. A recent takeover attempt involving the big pharmaceutical firms Pfizer (NYSE:PFE) and AstraZeneca (NYSE:AZN) also went nowhere after the latter backed out at the last minute.

These and other big deals gone sour have been getting plenty of media attention, possibly giving the impression that M&A activity is weakening. But that couldn't be further from the truth.

According to software firm Dealogic, which offers multiple services including M&A analytics, failure rates for M&A deals have been falling since last year and are near pre-recession levels. What's more, global M&A volume has reached nearly $2.3 trillion this year, a 43% year-over-year increase and the second-highest yearly total ever (after $3.1 trillion in 2007).

And it looks like there's plenty more to come.

In a second-quarter letter to shareholders, legendary investor Jeremy Grantham predicted the greatest M&A boom ever. "I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two," he wrote. "If I were a potential deal maker, I would be licking my lips at an economy that seems to have enough slack to keep going for a few years."

Those are statements to heed given the reputation of Grantham, chief investment strategist at GMO, the Boston-based asset management firm he co-founded in 1977. Since then, he has earned a spot among investing's all-time greats with, among other things, an uncanny ability to spot asset bubbles. He's called all the major ones of our time, including the Japanese stock bubble of the late 1980s, the dot-com bubble of the late 1990s and the 2008 housing bubble.

So what's that connection between M&A and asset bubbles? Well, in this case, Grantham expects the former will lead up to the latter, although, as his comments suggest, this could take up to a few years.

In the meantime, there are catalysts galore for an M&A boom of historic proportions, and Grantham cites about half a dozen: low interest rates, relatively high profit margins, the economy being in a relatively early-stage recovery, massive labor reserves and plenty of room for growth in capital spending.

Other analysts also pointed out that, because of high stock prices, it's often cheaper for companies to make acquisitions than buy back stock. Plus, many companies have accumulated immense cash hoards and, with the economy seemingly on the mend, are becoming more likely to take some risks with their cash rather than just sitting on it.

Thus, it seems there's a clear opportunity for investors to profit from dealmaking during the next couple years or so. The question is how best to do it.

Since it's virtually impossible for individual investors to keep up with all the M&A activity going on and be able to separate fact from rumor, they're better off leaving the task to mutual funds and/or exchange-traded funds (ETFs) designed to capitalize on such activity. There are a couple options worth considering.

A top choice -- and one that happens to have outperformed 95% of its peers during the past decade -- is a mutual fund called Merger Investor (MERFX). Like most funds focused on M&A, MERFX uses a merger-arbitrage strategy in which it buys the stocks of takeover targets and shorts the stocks of the companies doing the buyouts. This is because the stock of a company being acquired usually goes up, whereas the acquiring firm typically sees its stock fall.

MERFX usually allocates at least 80% of fund assets to M&A (but will try to capitalize on reorganizations and bankruptcies to some extent, too). According to Morningstar, the fund devotes a big chunk of its research budget to law firms and other outside experts to learn as much as possible about potential deals and their chances of actually being inked.

Investors who prefer ETFs should consider the IQ Merger Arbitrage ETF (NYSE:MNA), which tracks an index of companies that have announced they're being acquired. But rather than shorting the stocks of the acquiring firms, the fund simply shorts broad domestic and international stock indexes (the S&P 500 and MSCI EAFE) as a partial equity hedge.

Not pairing up long and short positions like MERFX hasn't affected long-term performance, though. The fund's three-year record is actually slightly better than MERFX's.

There's also the Credit Suisse Merger Arbitrage Liquid ETN (NYSE:CSMA), an exchange-traded note that, like MERFX, is long buyout targets and short the acquiring firms. However, results indicate the fund hasn't employed merger-arbitrage nearly as effectively. Indeed, none of the investments I've described have has posted exciting returns lately, but that could change dramatically if M&A picks up like Grantham predicts.

M&A Fund Performance
Heading YTD 1 year 3 year 5 year 10 year
Merger Investor (MERFX) 1.9% 4.0% 4.0% 3.5% 3.9%
IQ Merger Arbitrage ETF (MNA) 2.9% 4.7% 5.5% N/A N/A
CS Merger Arbitrage Liquid ETN (CSMA) -3.7% -2.7% 0.1% N/A N/A
S&P 500 5.1% 15.5% 19.6% 16.4% 8.3%

Risks to Consider: Considering the long-term performance of merger-arbitrage-focused investments, it's possible their strategy may not be capable of market-beating returns. Also, Grantham sees M&A eventually pushing the stock market up to "true bubble levels."

Action to Take --> If you're intrigued by Grantham's assessment of M&A activity, consider targeting the potential boom with one or more of the investments I've described. Splitting your M&A allocation equally between MERFX and MNA might be the best option, since they're both solid performers and you'd get equal amounts of actively managed and passive index approaches. Or, if Grantham is right about the run-up to a bubble, simply tracking the market may prove an even better way to reap the rewards of the M&A surge -- if you manage to get out before the big pop.

P.S. Are you terrible at knowing when to sell? You're not the only one. Fortunately, a former trust fund manager created a two-part blueprint that reveals when to sell... and when to buy. It's been 85% accurate for over four years -- and just closed out a 70% gain. Click here to access it now.

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