Call Me Manny the Arb

The stock market may be tumbling, but I'm feeling a bit cocky: I've scored my first winner in the esoteric world of merger arbitrage. With the completion of InBev's $52-billion purchase of beer icon Anheuser Busch on November 18, I pocket a $7-plus profit on each of my 500 shares of BUD. That's something worth crowing about, especially in this wretched market.

Oh, did I mention that it took just five weeks to book that 11.4% gain? That's how much time elapsed between October 13, when I bought my BUD shares, and November 18. That's an annualized rate of return of 195%. A toast to my acumen.

Yet with some careful analysis and more courage, I could've done even better. On October 24, less than two weeks after I made my plunge, BUD itself was plunging, sinking to as low as $54.35 as panic-stricken investors engaged in that age-old art of selling first and asking questions later. If I had doubled down on my BUD bet at, say, $55 a share, I could have earned 27% on the second batch in barely more than three weeks. That would have amounted to an annualized return of 3,624%.

From just $107.88 $24.99 for Kiplinger Personal Finance

Be a smarter, better informed investor.

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

But the real story of my adventure isn't how much I made -- or could have made -- but how much opportunity remains in "deal" stocks. In a good year, you can earn 10%, maybe 12%, with minimal risk by investing in a package of takeover stocks. Nowadays, the market is giving you plenty of chances to make 10% in a month. Of course, all this assumes that you invest in deals that actually go through. If you guess wrong, the consequences can be extremely painful, as I learned firsthand in my initial foray into merger arbitrage. More about that in a sec.

First, an explanation of merger arbitrage. When one company announces plans to take over or merge with another company, the target's price usually jumps on the disclosure -- but not all the way to the deal price. The gap between the post-announcement price and the consummation price reflects the possibility that a deal may collapse or be renegotiated on less-favorable terms. It also accounts for the time value of money.

A merger arbitrageur invests in the target company after the deal is announced. The aim is to capture those final few dollars -- or pennies -- of appreciation. If an arb is right often enough in determining which deals will reach fruition, he or she can earn decent, steady returns without much volatility -- and without much correlation to the overall stock market. But if a deal falls apart, the target company's stock usually collapses.

Nowadays, investors worry that just about every deal will disintegrate. Hence, spreads between current share prices and consummation prices are at ridiculously wide levels. On average, says Roy Behren, a co-manager of Merger fund (symbol MERFX), the deal stocks he and his colleagues are following are priced to deliver annualized returns "north of 30%." "It's all due to pervasive fear in the marketplace," says Behren. "People are afraid of anything that entails risk."

Behren offers these two examples of some of the abnormalities in merger land:

• Dow Chemical (DOW) has a deal to acquire Rohm & Haas (ROH), a maker of specialty chemicals, for $15.3 billion, or $78 a share. Shares of Rohm & Haas closed November 19 at $71.71. "This is a strategic deal," says Behren. "Dow has reiterated its commitment a number of times. The deal should close in mid February." Assuming consummation at $78, the annualized rate of return to mid February is 37%.
• Within a matter of weeks, a consortium of companies could complete the purchase of Puget Energy (PSD), a Bellevue, Wash., electric and natural-gas utility, for $7.4 billion, or $30 a share. Puget closed at $27.12 on November 19. Says Behren: "They're waiting for Washington state approval, which could come any time in the next couple of weeks. The stock is trading at a wide spread because people are concerned about regulatory approval and because it's a cash deal, which means there's financing involved." If regulatory approval comes soon, Puget shares could advance more than 10% in just a few weeks.

It all sounds so easy -- and it is, if you buy the right stocks. Unfortunately, I've also learned what can happen if you bet wrong. Last May, I bought 500 shares of Penn National (PENN), a casino operator, at $45.05. At the time, Penn had agreed to a takeover by two private-equity firms for $67 a share. Penn shareholders had already approved the deal, the financing was in place and the buyers would have to pay a $200-million breakup fee if they walked away. The deal was scheduled to close on June 15.

I learned of the Penn deal in a March article my colleague Tom Anderson wrote. The article made clear that this was a risky proposition -- in fact, it even quoted Behren as saying that Penn's low price was the market's way of saying that the deal stood only a one-in-three chance of reaching fruition. But greed -- the chance of making a 50% return in one month -- prevailed, and I pulled the trigger.

Big mistake. After a brief move into positive territory, my investment embarked on a long, painful slide. Penn traded in the high $20s when the company announced on July 3 that the deal was off (so much for the June 15 deadline). In return for letting its suitors walk away without having to face a nasty lawsuit, Penn accepted a $225-million breakup fee and what amounted to a seven-year, interest-free loan of $1.25 billion.

Should I have bailed sooner? Behren says there were plenty of warning signs that things were amiss: the rapid fall in Penn's share price, the collapse of other proposed leveraged buyouts and the daily drumbeat of news about banking-industry problems, which raised questions about whether the private-equity firms buying Penn would be able to get financing for the takeover.

To make matters worse, I held on to my Penn shares after the company announced the deal's termination. My rationale was that the breakup payoff would strengthen Penn's balance sheet and make it a much more formidable player in the gaming industry.

The stock, in fact, rebounded, hitting nearly $34 in early September. But little did I know that we were on the edge of the gravest financial crisis in generations. I sold my Penn shares on October 6 at $17.87. Ouch! (I should note in passing that I violated a cardinal rule of investing with my Penn misadventure: If the reason you bought a stock is no longer valid, sell it.)

If you don't have the time, inclination or stomach to buy individual takeover stocks, you could do a lot worse than to invest in the Merger fund. Year-to-date through November 19, the fund is flat. Not many other stock-owning funds can make that claim in 2008. Over the past five years, the fund earned 3.7% annualized. Over the past ten years through October 31, it returned 5.9% a year. Expenses, at 1.40% a year, are about average. The initial minimum investment is $2,000.