Getting Rich Off Merger Mania

You can benefit from the corporate buyout boom in several ways, the easiest of which is just to watch it happen. Mergers, acquisitions and stock buybacks erased a record $548 billion worth of shares from the U.S. stock market last year, making the remaining shares that much more dear. The 22% return of Standard & Poor's 500-stock index over the past year (to June 11) is due, in part, to the splurge. Plus, the buying sends a clear signal that stocks "remain attractively cheap," says Milton Ezrati, a market strategist at money manager Lord Abbett.

If you want to profit directly, you can use two very different strategies. The first is merger arbitrage, a tricky thing for most investors to pull off but one at which certain mutual funds excel. The second is anticipating which companies might become targets and buying up their shares before everyone else catches on. That's trickier still, but there are ways to narrow the field and improve your odds.

Invest with the pros

Merger arbitrage is a strategy for profiting from mergers that have been announced but not yet consummated. Typically, shares of the target firm immediately rise toward the announced purchase price but don't quite reach it. Buying shares of the target, then, is a calculated risk that the merger will be completed and the announced price will be realized.

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Profits from this strategy are modest but steady. About 95% of announced deals go through. And merger-arbitrage funds don't tend to rise and fall in concert with other stock funds, which makes them a good way to decrease the volatility of your portfolio.

One of the best arbitrage funds is Merger fund, a member of the Kiplinger 25. Merger (symbol MERFX; 800-343-8959) has been churning out steady gains since 1989 and has had only one down year (2002). In addition to taking positions in conventional merger deals, the fund buys into what it calls "pre-deal" situations -- firms that appear to be on the verge of being acquired. For example, it invested in utility holding company Mirant (MIR), shares of which rose 11% after the company announced in April that it would entertain offers from a suitor.

Another option is Arbitrage fund (ARBFX; 800-295-4485), which pursues a strategy similar to Merger fund's. It's much smaller ($167 million versus $1.8 billion for Merger fund), so it may be able to buy into smaller deals that Merger fund might pass up. But it has a higher expense ratio, 1.95%, compared with 1.37% for Merger fund.

In good years, a deal fund can return 10% to 15%. Some recent lean years, however, have dragged down the five-year annualized returns to about 6% for both Merger and Arbitrage funds. This year (to June 11), Merger was up 5% and Arbitrage 4%.

Crystal-ball gazing

Anticipating takeover plays is more profitable, but it's not easy. One strategy is to look for industries with a high level of takeover potential. Citigroup market strategist Tobias Levkovich recently did this by focusing on sectors in which companies' cash-flow yields (cash flow per share divided by the stock price) greatly exceed junk-bond yields. The reasoning: Acquirers will borrow money by issuing junk bonds and use a company's cash flow (in this case, earnings before interest, taxes, depreciation and amortization) to repay the loans. The bigger the spread between the yields, the more potential for profit. Using this measure, he spotted opportunities in energy, utilities and retailing, among other sectors. Exchange-traded funds that track these industries -- for example, iShares Dow Jones U.S. Energy (IYE) -- could get an extra boost if private buyers are willing to pay high premiums for these kinds of companies.

Zeroing in further, companies with steady cash flow, low debt and lagging share prices are especially tempting targets for acquirers. These happen to be characteristics that many value-oriented fund managers seek. For example, David Katz, manager of Matrix Advisors Value fund, notes that five of his fund's holdings were acquired in recent months, and many others are rumored to be targets.

Possible deals

One potential takeover play, Katz says, is conglomerate Tyco (TYC). It has announced a plan to split into separate companies focusing on health care, electronics, and fire-protection, security and engineered products. "Splitting into three will create focused businesses that are attractive to acquirers," says Katz. He pegs the value of Tyco's pieces, once separated, at $42 to $45 a share, well above Tyco's mid-June price of $34. Other potential targets, he says, include security-software maker Symantec (SYMC, $20) and clothing retailer Gap (GPS, $18).

Kent Croft, manager of Croft-Leominster Value fund, thinks "asset-rich" companies are natural takeover targets, particularly when they are out of favor. One example is forest-products giant Weyerhaeuser (WY). Its 6 million acres of prime timberland alone are worth more than $100 a share, Croft says. But concerns about the housing slowdown's effect on lumber prices have dampened enthusiasm for the shares, which recently traded at $82.

Croft also says some small oil-and-gas exploration companies could arouse interest from bigger energy companies looking to expand their North American reserves. On his list of possible targets are Ultra Petroleum (UPL, $58) and Bill Barrett (BBG, $36).