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Market Update

Can You Profit From the M&A Spree?

It's a record year for M&A deals in corporate America. Contributor John Waggoner explains what that means for investors.

Companies and people have similar urges sometimes. People like to build big houses; companies like to build large headquarters. People worry excessively about how the world views them; so do corporations.

But one of the biggest similarities between corporations and people is that when they have a lot of money in the bank, they like to spend it. And lately, corporations have been spending lots of money on buying other companies. Can you make money from the M&A spree? Possibly--but it's not easy.

So far this year, U.S. companies have embarked on an unprecedented buying spree, with 8,562 M&A deals totaling a record $1.9 trillion, according to Dealogic. (Global M&A activity, at $3.9 trillion, still lags 2007's $4.6 trillion.)

Why the urge to merge?

Cash 
Nonfinancial companies in the S&P 500 held $1.32 trillion in cash and equivalents as of June, according to S&P, just a hair shy of the record $1.33 trillion held at the end of the year. At current rates, that trillion-plus in cash is earning virtually nothing.

Sooner or later, companies have to do something with all the cash on their balance sheets. At the moment, companies seem disinclined to share it with employees, either through hiring or giving raises. Unlike paying dividends or buying back stock, acquiring another company offers the possibility of increasing your market share or securing new product lines.

For example, Dell's $67 billion buyout of data-storage company EMC will give Dell the ability to offer storage, networking, and servers to a wide array of clients. And, while Dell has many in-house talents, the company hasn't been noted for its software prowess--something it will also get via EMC's 80% stake in VMware. As Morningstar analyst Peter Wahlstrom notes, the Dell/EMC merger means that the company will be able to sell fully integrated solutions--including storage, networking, and servers--to a number of markets.

Peer Pressure 
The current wisdom in technology, particularly in the chip-making area, is that bigger is better. Computer chips, whether they're processors or storage, are highly commodified, and it's always an advantage to be the biggest and lowest-cost producer. When one company combines with another, other companies decide that's a pretty good idea, too.

For investors, trying to play the M&A game is difficult. Let's start with the fact that you're unlikely to know anything about a merger in advance--and if you do, the Securities and Exchange Commission would probably like to know just how you found out.

For another, companies often overpay for their acquisitions, which is why the stock price of the acquisitor typically falls on the announcement and the price of the target usually soars. In a sign of how frenzied the M&A market has become, sometimes the share prices of both the target and the acquisitor rise, but this is fairly unusual.

And finally, many mergers end unhappily. The AOL/Time Warner merger was a misfit of legendary proportions. Hewlett-Packard (HPQ) managers are still trying to explain why things when so wrong when HP merged with Compaq. Companies that merge in haste--say, at the peak of an M&A-frenzy cycle--often wind up repenting at leisure.

One way to make an M&A play would be to invest in the companies that make money on arranging the deals--the investment banks. Unfortunately, big investment bankers like Goldman Sachs (GS) and Morgan Stanley (MS) do other things aside from assist in mergers and acquisitions, and some of those lines--such as bond trading--haven't been terribly profitable this year. And many have been smacked by substantial legal bills. As of this writing, Goldman Sachs is down 9.4% this year, versus a 8.4% loss for the capital-markets industry, and Morgan Stanley has swooned 17.8%.

The reaction of companies' stock prices is so predictable that merger arbitrage can be a profitable, if unexciting, way to invest. In a nutshell, you buy the stock of the company being acquired, and you sell short the stock of the company making the purchase. Several funds specialize in merger arbitrage; they are generally conservative funds with low volatility and mild-mannered returns. Most wait until a deal has been announced before they invest and don't speculate on takeover rumors.

The top-performing merger-arbitrage fund, Gabelli Enterprise Mergers and Acquisitions AAA (EAAAX), has averaged a 5.17% annual gain the past five years. The oldest fund, Merger Fund (MERFX), has averaged 3.01% a year during the past 15 years. Morningstar assigns the latter fund an Analyst Rating of Silver.

Your best bet for being on the winning side of an M&A play is probably a value fund. Acquisition targets are typically considered undervalued, and that's what a value manager looks for, too. Dodge & Cox Stock (DODGX), for example, has about 4.08% of its assets in Time Warner Cable , 2015's biggest acquisition. Deutsche Large Cap Value has a 5.16% stake in Cigna (CI), which is on target to be taken over by Anthem (ANTM).

Most value managers don't look specifically for takeover targets; it's generally just a happy accident of their investment style. Oakmark Select (OAKLX), for example, benefited last year when TRW Automotive Holdings was taken over by ZF Friedrichshafen for $105.60 per share. The fund also benefited when AT&T (T) offered to buy DirecTV and when Actavis (now Allergan ) bought Forest Laboratories.

The deeper the value approach, the more likely the fund is to find a takeover or two in its portfolio. Franklin Mutual Shares (TESIX), for example, often looks for companies with assets that are temporarily depressed because of short-term earnings disappointments, lawsuits, or other perceived negatives. And it uses merger arbitrage when it thinks it will boost returns.

Bear in mind that merger season, as with all things in the market, will eventually pass. Though, in a period where companies are cash-rich but earnings are hard to grow, the merger season could last for quite a while.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

John Waggoner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.