How Investors Should Handle the M&A Frenzy

If you were a shareholder in 3PAR (NYSE: PAR), McAfee (NYSE: MFE) or Cogent (Nasdaq: COGT) this summer, you’re likely quite pleased with the news that each of those companies will be acquired a nice premium.
[Read: Why Today’s Intel Deal Makes Tech Even More Appealing]

But the good news comes with a catch: should you take profits? Or should you hold on in hopes of further gains? The short answer: it depends.

To figure out how to play the buyout game, we first need to separate any buyout-related price spike into two camps.

The first camp involves stocks trading below the price a buyer has offered. This indicates that the deal may not go through due to regulatory anti-trust reasons, or simply because the buyout target has made it clear that it has no intention of selling the company in the near-term. If the stock is at a discount because of anti-trust concerns, then try to assess how real those concerns are. The government would likely never allow a merger between two companies that control most of a market, such as Time Warner (NYSE: TWX) and Comcast (Nasdaq: CMCSA). But either of those firms would likely be able to acquire a smaller regional player. And if the stock is at a discount to a buyout offer because of a reticent seller, a sweeter offer may well emerge. But you need to ask yourself if there is significantly more upside to be had by sticking around. If you’re sitting on a +50% gain and hoping for another +5% or +10%, then the answer is probably not.

But what about stocks that are trading even higher than the buyout offer? Shares of Cogent now sell for $11, roughly 5% above the buyout offer made this week by 3M (NYSE: MMM). Investors are betting that a better offer will emerge now that Cogent has expressed a willingness to be bought. By my math, 3M is getting Cogent on the cheap, and Cogent might fetch a higher offer. [Read how David identified Cogent as a “Deep Value” stock before 3M’s buyout offer.]  But it’s unclear if such an offer will emerge. If it doesn’t, then shares will soon fall back below the $10.50 offer price. (Buyout prices often reflect a small discount to the offer to account for the small chance that a deal falls through).

Playing it safe doesn’t always pay off. In the case of 3PAR, investors might have looked to book profits when Dell (Nasdaq: DELL) offered to buy the company for $18 a share and the stock immediately zoomed to that price. A bidding war ultimately ensued, pushing shares to $27. That scenario was highly unusual, but you can make an argument for sticking around for at least a few days, as there was little risk that shares would fall much below that $18 offer.
[Read: This Company’s 10-Day, +169% Run is Heating up an Entire Sector]

Rumors = profits
But what should you do when rumors push a stock up sharply? Shares of Saks (NYSE: SKS) are up nearly +25% on Tuesday to $8.25 on rumors of a potential buyout. Trouble is, rumors are often put out there by traders looking to “pump and dump” a stock. The Saks situation is a bit tricky because the rumored price is $11 a share, sharply higher than current levels. In this instance, the rumors have more merit as they are being disseminated by a legitimate media organization — The U.K.’s Daily Mail. But if these rumors had emanated from Wall Street’s trading floors, then investors would be smart to sell as quickly as possible, as these deals rarely ever actually materialize.

Even as shares of Saks may have more upside if a deal materializes, it would be foolish to commit fresh money. There’s a reason why shares are stuck well below that potential price: hundreds of investors have done the math and concluded that the risk and reward are in balance as to whether a deal happens. Unless you possess inside information (which you shouldn’t), then you have no greater insight as to how this plays out compared to the rest of the crowd.

Action to Take –> You can’t ignore this M&A frenzy, as it is likely to continue into the Fall. Cash-rich firms, especially in the area of high-tech, need deals in order to get back into growth mode. Yet as I’ve written before, it’s unwise to try to buy stocks you think may be good buyout candidates — as the vast majority of buyout rumors never come to fruition.

But it is wise to consider whether a stock is very undervalued in a consolidating industry in the context of a broader investment analysis. For example, I think that CommVault (Nasdaq: CVLT), Micron Technology (NYSE: MU), Blue Coat Systems (Nasdaq: BCSI), Integrated Silicon (Nasdaq: ISSI) and Tellabs (Nasdaq: TLAB) are all reasonably-priced, have strong customer bases, and toil in industries that are currently seeing a good amount of deal-making. I’d buy those stocks on their fundamentals. Any buyout offer would be icing on the cake.