3 Ways to Cash-in on the $3 Trillion Merger Wave Next Year
Since the financial crisis in 2008, corporate executives have taken a cautious approach to making big decisions. This has been especially the case with mergers & acquisitions (M&A).
But according to a recent survey from Thomson Reuters and Freeman (a consulting firm), it looks like 2011 is shaping-up to be a boom year. The forecast is for more than $3.0 trillion in transactions on around the globe in 2011. Consider that 2007 saw $4.3 trillion in deals.
Why the rebound? There are several reasons. First of all, companies need to find new sources of growth. No doubt, M&A is an effective way to do this.
What’s more, the cost for acquisitions is fairly cheap, in light of rock-bottom interest rates. The result is that it does not take much savings and operational improvement to get attractive returns on acquisitions.
Of course, an M&A surge will be beneficial for investors, since most deals happen at a premium to their market values. Yet there are certainly some risks — after all, it can be incredibly difficult to pinpoint buyout targets. [See: “36% Gains From a Takeover — and Two More Stocks That Could Follow”]
Despite this, there are still some ways to play the M&A game:
1. Focus on the hot spots
The Thomson survey shows that the key industries that are prime targets for takeovers include real , financial services and emerging markets. As for the first two, these sectors have been generally out of favor. In other words, a buyer is really looking for a way to expand its footprint at a good valuation.
And yes, the emerging markets are the opposite, since valuations have been frothy. But for large companies, it is a must-have area to expand business, so valuations may continue to be robust as deal making heats up.
A good way to invest on these themes is to focus on exchange-traded funds (ETFs). Some options include Vanguard Emerging Markets (NYSE: VWO), SPDR KBW Regional Banking (NYSE: KRE) and SPDR Series Trust SPDR Homebuilers (NYSE: XHB).
2. Merger arbitrage (aka “Merger arb”)
Merger arbitrage is actually a low-risk way to invest in M&A. The approach is to focus on mergers that have already been announced. For example, suppose that Microsoft (Nasdaq: MSFT) has agreed to purchase Salesforce.com (NYSE: CRM) in an all-stock deal. In many cases, the buyout price will be higher than the current price of the target.
The main reason is that there is a risk that the deal may not get done. This may be because of antitrust problems, negotiation problems and so on.
Thus, a merger-arb fund will evaluate the risks and see if there is enough return to justify an investment. While this sometimes falls apart, it tends to have a good track record — especially when the M&A market is active.
While fairly new, there are several merger arb ETFs. One just came out within the last month: the Credit Suisse Merger Arbitrage Index (NYSE: CSMA). It is a passively-managed fund that is based on a sophisticated merger arb index composed by Credit Suisse.
Another ETF to consider is the IQ ARB Merger Arbitrage ETF (NYSE: MNA).
3. Boutique investment banks
These companies can have volatile revenue and earnings, but keep in mind that several mega deals can result in huge fees for boutique investment banks.
When the M&A market heats up, earnings can definitely pile up. Consider Lazard (NYSE: LAZ). In the latest quarter, the firm saw its deal advisory revenue spike +29% to $160.7 million. Just think what will happen if 2011 turns out to be a stellar year for deal making…
Lazard has also been making strides with its asset management business. This unit grew +32% in the latest quarter. Yet the main driver will be the deal business. And Lazard has a global investment-banking platform with some of the best professionals in the business.
Action to Take –> Investing in ETFs can be an effective way to benefit from the merger wave. However, the returns can be hum-drum because merger-arb focuses on low-risk opportunities.
So if you’re looking for big returns, a better approach is to invest in a company like Lazard. The company should continue to post strong revenue and earnings growth for the next couple years. At the same time, Lazard is trying to reduce its compensation costs. But more importantly, the shares trade for a decent valuation of 2.4 times revenue.