Forget buy and hold strategies: make money from takeovers

Forget buy and hold strategies: make money from takeovers

It's no secret that with global economic headwinds limiting opportunities for expansion, companies are looking for new ways to generate growth. Pegged against a backdrop of low borrowing costs and a lower Australian dollar, analysts are expecting interest in Australian companies from foreign investors to dramatically increase over the coming months.

And while companies get busy reaping the benefits from acquisitions, so too can investors and traders, like you.

If analysed properly, takeovers can offer unique risk versus reward characteristics, and knowing how to separate the good from the bad can be very profitable. Take the hostile Warrnambool Cheese and Butter Ltd bid in early 2014 as an example. Members who followed our recommendation to buy stock in September 2013 at $6.00 and sell it in January 2014 for $9.40, made a 56.7% return in only four months.*

Today we share with you what takesovers are, how they work, why there is money to be made from them and our top five secrets to make money from them.

What are takeovers?

Takeovers simply result from one company acquiring or merging with another. Most common takeover strategies include classic takeovers and ‘schemes of arrangement’. (We tend to use the term ‘takeover’ as a blanket statement for M&A activity.) While the reasons for acquiring or merging vary, the actual reasons do not necessarily matter to us as takeover arbitrageurs.

The differences between classic takeovers and 'schemes of arrangement' are as follows: 

Schemes of Arrangement
  • A scheme is an all or nothing proposition, whereby an outcome is known by a certain date.
  • If the court and shareholders approve the scheme, the bidder obtains 100% of the target. If the scheme is not approved, the bidder gets nothing.
  • Schemes of arrangement are useful in friendly situations, as the target’s board has endorsed the proposal and the company’s shareholders must approve the scheme. However, because they are friendly, they don't often result in higher prices, but as low-risk arbitrages with a greater likelihood of being concluded, they can be a safer bet than takeovers.
  • As a broad generalisation, the approaches are often hostile and higher prices may need to be offered to get the deal over the line. 
  • In contrast, depending on the conditions of the takeover, a bidder may end up acquiring only a percentage of the target.
  • Takeovers are more useful in hostile situations whereby the bidder controls the process. Takeovers tend to result in more raised bids.
  • In takeovers there is a much higher likelihood of seeing new bidders emerge. Company boards may be able to seek out competing bids or the resistance of the board may flush out other interested parties. Bidding wars are historically where we've seen our best profits.

Why there is money to be made in takeovers

Rivkin Rule No 2. "It is rare that the first price in a takeover is the last takeover price."

As per our second Rivkin Rule, the first price in a takeover bid rarely the last price, and there are a couple of reasons for this. Firstly, one company bidding for another can be likened to any other situation in which one party is offering a price to another. Think about if you are bidding on a house. Your first price is always below what you are ultimately prepared to pay and hence, not your final price. You simply never show your best hand first. Companies almost always offer below what they are prepared to pay so that if they are rebuffed, they have some room to move, space to negotiate.

The other reason that the first bid is rarely the last is that once a company is the subject of a takeover bid, it is all of a sudden ‘in play’. Other companies sit up and take notice and various competitors of the bidder are likely to have a look at the situation with a view to potentially bidding themselves, in an effort to prevent their competition from acquiring a strategically important target.

So the initial bidder is often likely to raise their bid if required, and the bid itself often alerts other parties, which increases the chances of another bidder entering the fray. And that is when takeovers can get truly exciting! Two (or more) companies battling it out for the target, raising their bids over each other to shareholders’ great delight.

How to make money from takeovers

Rivkin Local combines three strategies, of which the event strategy is one (the other two include the blue-chip and income strategies). Here are the top five things we look for in a takeover offer before we recommend any investments to our members as part of our event strategy:

1. A cash bid
Rivkin Local's event strategy prefers to buy into a company that is under an all-cash offer, as this provides a higher degree of safety than the ‘scrip’ or share-based offers. Payment in the form of shares means that your potential return will fluctuate, depending on price of the bidding company’s shares. On the other hand, payment in the form of cash gives you a certain outcome.

Cash payment is the ideal scenario, although there are often many other elements to consider. Offers might be all cash OR cash plus stock OR all stock, all of which might be attractive in certain circumstances. For example, deals which involve an offer of all cash OR stock alternatives can allow us to lock in a cash profit plus have exposure to any upward movement in the stock price of the acquiring company.

When a company becomes a takeover target, documentation will be sent to shareholders providing them with options (if available) that might include cash, stock or a cash/stock combination. Shareholders can wait until close to the deadline before making their decision; in this way shareholders have time on their side and can wait before choosing to take the cash, or take shares if that is the more profitable outcome at the time. This is why takeovers sometimes provide a free call option on the bidding company.

2. The ability to buy stock in the target company at or around the bid price

We usually buy into the company being acquired, where a small discount exists between the market price and the offer price. So, if the bid is not increased, we will still make a small, but nonetheless profitable return.

3. Preferably a hostile bid

You want to buy into a target company that offers plenty of upside should the offer be raised. This often happens in the case of hostile bids, where the acquiring company needs to increase the offer to win over the board and shareholders of the target company OR if another bidding company emerges. Even in friendly takeovers, the acquiring company sometimes needs to provide a little more incentive to win across some stubborn shareholders. The combination of making a small arbitrage profit plus the combined potential upside in a higher bid provides a good trade.

4. The bidder is bona fide
It's important to ensure that the bidder is a bona fide bidder. By this, we mean a bidder that is not likely to default on its takeover bid commitments. So you want the bidding company to have a lot of financial firepower. As an example, if a small mining company capitalised at $75m were to launch a takeover bid for Rio Tinto, it would be laughable. However, if BHP Billiton were to launch such a bid, they are as bona fide as you can get. So make sure you check the status of the bidder.

5. Conditions that aren’t prohibitive

The conditions of the bid are also essential to assess. We look for conditions that are not likely to threaten the likelihood of the deal completing. One such clause is whereby market-linked conditions that allow the bidder to walk away from the deal, should the general stock market fall by a certain amount. Takeover documentation is often long and laborious and we go to great pains to comb through the paperwork to familiarise ourselves with the parties and risks involved.

M&A activity is pegged to increase in Australia in 2015; by utilising the above five tips, you're likely to find some strong investment opportunities this year. 

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