Betting on merger deals demands nimble trading

WITH global mergers and acquisitions (M&A) on the rise and 2010 already being hailed
as a blockbuster year, it might seem easy to benefit from sudden equity gains on the back of deals. But despite the impressive stock swings in response to M&A news, traders should be wary. Betting on deals that might not happen can be costly and – assuming one isn’t engaged in illegal insider trading – it is very difficult to get ahead of the crowd.

At a glance, the potential returns from trading contracts for difference (CFD) on the possibility of M&A action are hard to resist. Cable & Wireless Worldwide, for example, has seen its share price jump 8.4 per cent since rumours surfaced of possible bids for the company by AT&T and Singapore Telecom. The stock price of PotashCorp, meanwhile, leapt 27.7 per cent in a single day’s trading after reports of BHP Billiton’s attempted takeover, and that of Australian gold-miner Andean Resources soared 45 per cent after Goldcorp outbid Eldorado Gold for the company.

The tactic therefore seems simple – just go long on the target company. The object of a buyout always sees its price rise when the market senses a deal because the buyer usually pays investors a premium over the share price in order to gain control of the company. Conversely, traders should go short on the buyer company due to the anticipated cash outlay.

This is all very well, but how is a trader to know which stock to pick? Once the official confirmation of a deal comes through, any benefit is likely to be priced in already. IG Index’s David Jones says: “It’s quite difficult – you are going on rumours and you have to be the first to spot it. If you’re following the rumour, you may have missed a significant chunk of the profit already.”

Which means that traders looking to gain from M&A movements have to be both cautious and nimble. Those late to the game could consider buying while the stock of the buyer company is low, either on the basis that the deal might not happen (as with Prudential’s buyout of AIG) or that a drop in the firm’s share price might represent a temporary dip due to the one-off cost of the acquisition.

A better tactic, however, is to get to know a sector in which you think mergers are likely and invest before the crowd. Analysts points to mining as one such sector, in which cash-rich, large-cap companies are eyeing up small-cap, mining exploration firms that often lack the capital to develop their discoveries. For example, aside from its hostile bid for PotashCorp, BHP Billiton is also rumoured to be considering a buyout of Anadarko Petroleum Corp, BP’s US partner.

Likewise, the aviation industry could also be ripe for some bidding wars, with British Airways and Iberia – due to merge later this year – already having compiled a list of 12 potential takeover targets. Regarding the sector as a whole, ETX Capital’s Mark Priest says: “A possible consolidation between some main players is inevitable at some point.”

As to which players and when they will lay their bets, it is anyone’s guess – which is what makes trading on M&A deals so risky and, potentially, so rewarding.