Banking On Merger Mania

By Aaron Levitt | October 17, 2010 AAA

As the economy continues to ebb and flow, many investors are having trouble gauging the stock markets. With each bit of news, either good or bad, it seems that the broad stock market reacts in wild swings. This severe increase in volatility requires new levels of sophistication in portfolio construction. Numerous investors are looking towards market neutral strategies or portfolios that can make money in any environment as a way to ride out the storm. One such strategy is riding high on a recent wave of corporate deal making - this might be just what investors are looking for.

IN PICTURES: Eight Ways To Survive A Market Downturn

$1.8 Trillion
With interest rates still at paltry levels, corporations with excess cash are feeling the pain just as much as retirees. With nearly $1.8 trillion sitting in the S&P 500's coffers earning next to nothing, it is no surprise that merger mania has returned to the stock market. Merger activity has surged nearly 79%, year over year. Bloomberg reports that nearly $1.6 trillion in takeover deals have been announced so far in 2010, with $562 billion in the third quarter alone. This has been the fastest pace since the global slowdown. Companies in the S&P 500 are trading at just a forward P/E of 12.5, well below the 16.5 historical 20 year average.

With stocks so cheap and so much cash lining the pockets of business, mergers and acquisition are an ideal way to deploy that cash. For example, Intel Corporation (Nasdaq:INTC) with nearly $15 billion on its books, recently bought the wireless unit of chipmaker Infineon (NYSE:IFNNY) for $1.4 billion and made a $4.7 billion offer for McAfee (NYSE:MFE).

It is within this deal making that investors can profit. At its simplest, arbitrage involves profiting from the difference between the deal offer price and the current stock price. It's in these $1 to $2 differences, which arbitragers hope to profit from. The risk in the trade involves if the deal falls through or at happens at a much lower amount. Many hedge funds add short positions in the acquirer's stocks or futures contracts to circumvent this risk. However, merger arbitrage works best over several different deals and opportunities, requiring heavy capital constraints making it pretty inaccessible for most retail investors.

Staying Market Neutral
As investors crave more advanced tools for portfolio construction, Wall Street complies. The exchange-traded fund boom has given investors some choice within the merger arbitrage space.

The Credit Suisse Merger Arbitrage Liquid Index ETN (Nasdaq:CSMA) is the newest entrant to the space. The underlying index is rebalanced every five days, rather than monthly or quarterly, allowing for the fund to capture these event driven gains. Expenses run at a relatively cheap 0.55% and back testing of the underlying index results in a 6.54% annual return over the last 5 years. The IQ ARB Merger Arbitrage ETF (NYSE:MNA) follows a somewhat similar strategy.

During the very active M&A and private equity cycle of 2003-2007, the S&P 500 Value index outperformed its growth twin by nearly 30 percentage points. Another way to play this boom in mergers may simply be to bet on value stocks. The iShares S&P 500 Value Index (NYSE:IVE) and iShares S&P Mid Cap 400 Value Index (NYSE:IJJ) might be the real winners in all of this merger growth. In addition, just about 33% of recent merger activity has been in the energy sector. As larger energy companies look for new shale plays and reserves, both the PowerShares S&P Small Cap Energy (Nasdaq:XLES) and Jefferies TR/J CRB Wildcatters E&P (Nasdaq:WCAT) could see their prices rise.

Bottom Line
With cheap stock valuations and large cash hordes, merger mania has returned to the markets. As more investors look for alternatives to stay market neutral and protect their portfolios, opportunities exist to profit from this growth in acquisition activity. By using the previous merger-arbitrage funds or value ETFs, investors can add the strategy to their portfolios. (While acquisitions can be hostile, these varied mergers are always friendly. To learn more, see The Wonderful World Of Mergers.)

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