Tuesday, January 21, 2020
For the past two weeks, I’ve been explaining to you why buying stocks of takeover targets can be so profitable.
The thing is, this strategy isn’t for everyone. After all, it’s riskier than buying blue-chip stocks or diversified mutual funds.
But as I’m about to share with you, there’s also a safer way to invest in takeover action.
In fact, with this simple strategy, you could earn 24% or more a year… with very little risk.
Sound too good to be true? Let me show you how to do it.
The ABCs of Takeover Arbitrage
Takeover arbitrage sounds exotic…
But it’s very straightforward. Here’s how it works:
Let’s say Acme Widgets receives a takeover offer at $100 per share. The stock had been trading for about $50 before the news came out — but now it shoots up in price.
The thing is, it doesn’t shoot all the way up to $100. It only goes to about $94. The “spread” between $94 and $100 is the risk premium. It reflects the possibility that the deal might not go through.
But perhaps surprisingly, only about 16% of announced takeover deals fail to close. And with friendly, all-cash offers, the failure rate drops to just 5% or so.
In other words, for 95 out of 100 takeovers, that spread is risk-free money.
To use this strategy, simply buy shares of the target company after a deal is announced. Then wait for the deal to close. When it closes, you’ll have earned the 6% spread between $94 and $100.
But wait — because it gets even better…
Here’s Why Returns Can Reach 24%
You see, that 6% spread isn’t an annual yield. It’s a total yield.
So if you do this trade four times a year, your total yield could add up to about 24%.
As Harris Arch of DuPont Capital Management notes, “Merger arb is about the recycling of capital.”
That’s the beauty of merger arbitrage:
By earning a small profit in a short period of time, and then repeating this trade a few times a year, you can earn a handsome return.
Hard Data for the Skeptics
Perhaps you’re skeptical.
You shouldn’t be.
Merger arbitrage is a battle-tested strategy. It’s been a mainstay of institutional and high-net-worth portfolios for decades. Why?
Because as Aaron Brown of Bloomberg notes, it offers “equity-like returns with bond-like risk.” In other words, big returns for a fraction of the risk.
Furthermore, there are two other reasons to be bullish on this strategy right now…
Two Other Reasons To Join the Party
First, as I’ve shared in previous columns, 2020 promise to be a record year for M&A — which means it’ll be a rich year for arbitrage opportunities.
And as you can see in the chart below, higher levels of merger activity have historically been associated with higher returns.
Second, merger arbitrage returns get an additional boost when interest rates are rising. And after the recent rate cuts, the Fed’s next move is widely expected to be an increase.
How much could this boost merger arbitrage returns?
Based on research from Index IQ, a one-percentage point increase in the Fed funds rate typically leads to a two-percentage point increase in merger arbitrage investments.
So, are you ready to position yourself for 24% (or more) annual returns?
No Heavy Lifting Required
This isn’t where I tell you to scan the daily headlines for takeover announcements. That would take too much time and effort. Plus, it’s not necessary…
Two funds with proven track records invest in merger arbitrage opportunities:
The Merger Fund (MERFX) and The Arbitrage Fund (ARBFX).
Both are no-load funds with reasonable expenses (less than 1.5%). And both are run by managers who’ve been investing in merger arbitrage opportunities for over a decade.
Plus, each fund invests in over 50 deals, without much overlap…
So a small allocation to both funds can provide you with significant diversification — and can potentially position you for market-beating returns.
Ahead of the Tape,
Ahead of the tape,