STOCK WATCH


Dow Jones: A Lesson in Arbitrage

The risks -- and rewards -- of investing in shares of this takeover target are great.



You don't have to read The Wall Street Journal to learn about merger arbitrage. Just take a look at the stock of its parent company, Dow Jones, and the $5 billion bid from Rupert Murdoch's News Corporation to buy it.

In merger arbitrage, investors buy stock in takeover targets after the deals have been publicly announced. If that sounds like closing the barn door after the horses have escaped, you need to better understand how merger arbitrage works. Typically, the target's shares will sell at a discount to the transaction price. That discount is based on the time value of money and the risk that deal will fall apart or be renegotiated. Reasons for failure range from regulatory denials to financing problems to breakdowns in negotiating terms.

Success in the merger arbitrage game can generate nice, stable returns regardless of what's happening to the overall stock market. Success depends on "arbs" investing in deals that are actually consummated at prices above what they pay for the stocks after the deals are announced. If a proposed deal falls apart, the target's stock often craters.

Based on the current share price, most investors appear to be skeptical that even an experienced media dealmaker like Murdoch can persuade the controlling shareholders of the Bancroft family to sell Dow Jones to him. The stock (symbol DJ) closed on July 20 at $55, down 0.7% for the day. That's well below the $60 per share offered by News Corp. (NWS). Dow Jones stock trades at 37 times the $1.48 per share analysts expect the company to earn this year.

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"The stock price reflects the perception that there is a low likelihood of a counter bidder for Dow Jones," says Roy Behren, co-manager of the Merger fund. "And there's some uncertainty whether Rupert Murdoch will even be successful in acquiring this company." The Merger fund (MERFX), a member of the Kiplinger 25, does not own Dow Jones stock.

You don't have to be an arb to get a rough idea of the risks and rewards of an investment in Dow Jones' shares. Questions about where the Bancroft family stands on the deal and the lack of a formal agreement between Dow Jones and News Corp. make this deal riskier than most transactions, Behren says.

But if the Bancroft family consents and regulators approve the merger, investors stand to earn a nearly certain 9% in a matter of months. Conversely, if the Bancrofts balk, the stock could easily return to the mid $30s, the price at which it traded before news of News Corp.'s bid broke on May 1. Few people beyond insiders and the Bancrofts can really handicap the outcome of a shareholder vote. Everyone else is just speculating.

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