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Monday, May 8, 2017

Market Is Overvalued?

Merging Arbitrage Opportunities

  • The point is that merger arbitrage can deliver significant returns with less risk.
  • You can further improve your returns by not listening to the media, or even better, by listening but doing the opposite.
There are essentially two low risk options to invest in in these expensive markets. It’s true that the S&P 500 can go higher in 2017 and 2018, but it’s what we don’t see coming that scares me at these valuations.
The S&P 500 has a CAPE ratio of 29.14. This ratio has been higher only two times in history. 

Figure 1: S&P 500 CAPE ratio. Source: Multpl.
At such high valuations, you can expect long term returns—I’m talking 15 to 20 years from now—to be in the range of 4% per year including dividends, there is a high probability that 10 year returns will be negative as they have always been with the CAPE ratio above 27, and the risk of a 50% drop is imminent because shaky hands are pushing the market higher through index funds and ETFs while speculators just add fuel to the fire.
The two options that lower risks and increase returns are: 1) merger arbitrage if you want to remain exposed only to blue chips or S&P 500 companies and limit the volatility of your returns, and 2) emerging markets. Emerging markets are much more volatile, but they will give higher long term returns. Today I’ll discuss a few arbitrage opportunities that are attractive and should be followed.
What Is Arbitrage?
Merger arbitrage is making money on the spread between the agreed merger or acquisition price and the current stock price of the company being acquired. 
Arbitrage Opportunities
I’ll briefly review some merger arbitrage opportunities and discuss the risk reward story behind such investments.
AT&T & Time Warner
In my previous arbitrage article, I discussed the AT&T (NYSE: T) and Time Warner (NYSE: TWX) merger arbitrage opportunity. Since then, TWX is up 12.6%, which with two $0.4 dividends gives an annualized return of above 30% as TWX’s stock price slowly closes in on the offered acquisition price.

Figure 2: TWX stock price in the last six months. Source: Nasdaq.
There is always the risk that the deal won’t go through but in that case, you would still own a company with a PE ratio of 19.95 that’s a future potential acquisition target. Thus, the risk is similar if not lower than what the S&P 500 offers while the return is more certain and higher.
Bayer & Monsanto
This is a deal that even the great Warren Buffet invested in as he bought eight million shares of Monsanto (NYSE: MON).
Bayer offered to buy Monsanto at $128 per share making it a $66 billion deal. MON’s share price is trading at $114 at the moment which still gives a nice potential return of 12% with a 2% dividend yield while you wait for the deal to happen.

Figure 3: Monsanto’s shares have been slowly going towards the acquisition price. Source: Nasdaq.
As the companies are getting all the necessary approvals and selling assets in order to merge, the stock price has slowly been increasing and the arbitrage spread declining. Buffett invested in MON in Q4 2016 which means he has already made a nice 12% profit on his 8 million shares, or something like $126 million. Not bad for a few months.
Syngenta & ChemChina
This is a complicated deal as it requires approvals from more than 20 countries. 13 have been won, but approval still has to be received from Brazil, Canada, China, the European Union, India, Mexico, and the United States. This keeps the risk high but as the companies know what they have to do in order to get the approvals, the worst case scenario is possible delays. However, the deal is expected to close in the second quarter of 2017 which means there is still a nice 5% return to be made.
What’s interesting to learn from this case is how big a discount can be on a relatively sure deal. Short term panics on irrelevant news or delays give excellent buying opportunities. Syngenta (NYSE: SYT) has been trading at an average discount of 15% since the offer was disclosed.

Figure 4: Development of SYT’s discount on offer price. Source: Bloomberg.
The purpose of this article isn’t to recommend specific investments, but to show how there are other ways to make returns than to just merely be long the S&P 500. Don’t worry if you don’t like the above companies, there will be plenty of new deals coming as M&A activity continues to grow.

Figure 5: Merger and acquisitions in the United states by number and value. Source: IMAA Institute.
One of the latest opportunities is PPG Industries’ (NYSE: PPG) offer to buy Akzo Nobel for around €91 per share. The stock price jumped from €64 to €76 when the offer was made but there is still a nice 19% return plus dividends to be made if the deal closes.

Figure 6: Akzo Nobel’s share price in the last 12 months. Source: Telegraaf.
Management opposes the transaction for now, but this could lower the price and lower your risk while increasing your eventual return if PPG makes a higher bid. Merger arbitrage does reward the patient investor, the investor who can wait for the right deal and the one who can wait for the deal to go through.
The best arbitrage investment would be one where you would be happy holding the stock no matter what happens. If the deal goes through, you bank a nice short term return with low risk. If the deal doesn’t go through, you still own a great business, get the dividends, and wait for a new acquisition as the company is clearly in the market to be acquired.
To further improve your merger arbitrage returns, you shouldn’t listen to the news, or better, listen to the news but do the opposite. Two linguistic researchers, Buehlmaier and Zechner, have found that additional returns can be made in deals where the media is giving a low probability for success because irrelevant media news just increases the merger arbitrage spread.
Do the opposite of what the news and the herd says, focus on your own research, know what you’re buying or selling, and don’t worry about beating the market as it will come naturally.

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