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Using CFDs to Profit from Takeovers

Takeover Rumours
Written by Andy

There is no more exciting event in trading as when a stock you are holding rallies because of a bid approach. In the UK, rumours of takeovers are rife, so how do you distinguish between fact and fiction? Typically, in merger and acquisition, the market tends to reward the target company and punish the acquirer. But how can CFD traders take advantage of these big moves in the markets?

Many people have heard of the profits to be made from buying shares in a company that becomes the subject of a takeover or merger and acquisition (M&A) as they sometimes like to call it. Stocks tend to experience big moves at the early stages of negotiation. Whatever you can do with shares, you can do better with CFDs because of the enormous leverage that you can command. The profit on many equities can be realized about ten fold by using CFDs, as the margin rate is commonly only 10% of the true cost of the shares.

Finding the opportunities can be a challenge if you do not have insider information, but there are certain things that most takeover candidates have in common. For instance, most are small to medium size companies, as takeovers of large companies are difficult to fund. There are not many other large companies that can afford the price. But the best targets are usually underperforming companies which the firm taking over intends to turnaround, using their management skills. Buying an excellently managed company leaves little scope for increasing performance, but an underperforming company can make great gains under expert supervision Other candidates would include innovative small caps that may have a great product but because of inadequate management or plain bad luck find themselves in difficult situations with a depressed share price.

When a company is the target of a takeover, the value of the shares will usually increase, sometimes significantly. This is because the shareholders need to be compensated for agreeing to the deal. For instance Prudential, the UK insurance company, saw its share price drop 25 per cent earlier this year when it announced it was buying US insurer AIG’s Asian operation. Even the rumor of a takeover is sufficient to cause some price action, and by using contracts for difference you can make the gains without buying the shares. With the margin that you can get on CFDs, it’s even worth buying before any announcements, as on average you will make a good profit from the moves.

However, industry consolidation is often the main trend behind such mergers. Other pointers when looking for good targets include the company having large cash reserves; in particular small caps that have been underperforming and now trade at a disount to their cash reserves. This helps the acquiring company pay down any debt that they take on to make the deal go through, and makes the target that much more attractive. If there is a spate of insider buying, it often means that they know more than is public knowledge. An insider can sell shares for any of many reasons, such as needing to fund college tuition or buy a new house, so that is not necessarily a signal but insider buying is always for profit reasons. Another positive signal to look for when seeking suitable candidates is the presence on the shareholder register of a main investor with a past record of buying into enterprises and then trying to push a takeover in order to make a profit.

In such situations it usually makes sense to position yourself to take a longer-term view and take positions in companies that have good takeover possibilities over the medium-term. Since interest rates are low, the cost of financing a longer term CFD trading position for a year is fairly inexpensive. Whatever you decide make sure to do your own due diligence on the enterprise and make sure you understand the fundamentals of the company and the trends within the industry in which it operates.

So what to do if you hold shares in a company and it is approached by a prospective acquirer?

Question: I bought MLO stock (Melorio) a few days ago and I’m wondering how the acquisition works, as this is a new experience for me. If the offer is 225p, why are people selling this morning at 217.5? Is that in case the deal falls through? – Ted

Answer: You could hold the shares until the takeover deal has been finalised. There’s no panic as to what actions to take – these things take time. If you hold actual shares purchased through your broker then when the deal is finalised the cash will be credited to your account and the shares will be removed from your portfolio. There are two options:

1) The offer could fail to be accepted or withdrawn by PSON (Pearson) in which case the share price will fall. That is why some investors would sell now in order to bank the profits.
2) An additional offer may come in from another potential purchaser which would drive up the price or the MLO management may decide that the offer is too small and go back to PSON for a better offer.

Your options are:

  • Hold until finalised
  • Sell half now and hold the rest until finalised
  • Sell the lot now and bank the profits.

Many large companies use acquisition as a way of expanding, particularly into different territories, without the troubles of setting up an operation from scratch. If the target is priced at the level of its tangible assets, it makes an excellent prospect as it can always be split up and sold off if needed. The advantage of trading CFDs to profit from takeovers, real or rumoured, is that many people do not have enough investment capital to cover all the possible candidates. On the other hand, with just 10% margin typically required, you can take a position with CFDs in many companies as they become takeover candidates over the year, and the diversification of your interests means that you are much more likely to partake of the profits to be made when some takeovers inevitably happen.

How To Trade CFDs around a Bid

In truth, rarely can one predict the exact timing of a bid. However, there are several strategies that can be adopted by the CFD trader to make sure they have the best chance of making money from bid scenarios.

The first point is portfolio management. If you trade CFDs specifically for the big winners from bids, then a basket of stocks in the FTSE 100 and 250 that are perennially touted as being taken over are needed. Different sectors should be selected, as there is often a rotation of sectors consolidating from one month to the next.

As movements in prices magnify profits and losses, timing is crucial. Ideally, you should enter a stock that is seen as a bid target but when there is no news about it at that time. This is because by the time a bid makes it to the papers it may already be too late of the price action (ever heard the adage ‘buy the rumour, sell the news?’. Technical analysis is vital for support levels and should also be used when the stock has subsided.

Before you do anything you should also make sure you’re hedged, you just cannot put all your eggs in one basket when your trading strategy is based on a rumour. If it comes true, great, you made some very nice gains, but if it doesn’t then stock prices can retreat very quickly. Stop-losses are also important, as being disciplined in this area is as important as picking the winners. There are a number of factors in choosing the right price for the stop loss. Where would the stock trade before the premium of the bid story? Don’t just buy on the basis of a bid. What are the lows of the last 3-6 months? Where are the 200MA, 50MA and the RSI?

Merger Arbitrage

Some CFD traders make money after stocks have rallied up from the initial bid. Again, the CFD trader can utilise different techniques when looking at this area.

If there is a chance of a counterbid, it may be worth placing a buy order with a tight stop loss. Are there many players in the sector who could buy the company? Is there hidden value on the balance sheet? Is the stock trading above where the bid was offered and therefore the market is expecting a higher offer? Does the price reflect the bid or are there doubts on whether the deal will go ahead which is having an adverse effect on the share price? In such situations a possible strategy would be to buy in with a tight stop loss and set both exit and profit targets as this is the only way to ensure that small losses don’t get out-of-control.

In fact, one feature of the merger and acquisition activity involves hedge fund managers taking stock positions just after offer have been confirmed. This strategy is referred to as merger arbitrage and aims to exploit price differences between the day of the an acquisition’s announcement and the day of its completion. For instance on 8th September 2009, a day after Kraft’s initial 745p bid for Cadbury, a hedge fund manager utilized the merger arbitrage trading strategy by acquiring shares in Cadbury in what turned out to be a successful trade given the revised 840p offer in January.

Some traders will also short a stock after a rally up. If you think a takeover rumour is implausible then you shouldn’t be afraid to go against the market. For example, many stocks in the banking sector have been perennial bid targets yet no bid has taken place. Do you think the stock is overvalued at the potential bid price? Has the stock reached this price in the past and then come back?

Another strategy involves the pairs trade i.e. opening up two simulataneous CFD trades. In the majority of the cases when such rumours of mergers start circulating, the shares in the target company tend to rise while those of the rumoured acquirer tend to fall. The reason for this is that past studies have shown than mergers and acquisitions deals tend to add little (if any) and the acquirer often overpays for the privilege. So a way to make money is to short the acquirer and buy the target company using two separate CFD trades. Note that to make a profit you will have to reverse both CFD trades later and if you get them both wrong you could be in for some considerable losses!

The merger and acquisition arbitrage strategy is not suited for beginners, that’s for sure. What is clear is that if played correctly, trading CFDs around bids can turn out to be a very lucrative experience.

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