Playing M&A Through Mutual Funds

Though market indices have been hitting record lows for the year, one area is seeing new highs: mergers and acquisitions.

So far in 2000, around $1.65 trillion worth of merger and acquisition deals have been announced, according to Thomson Financial Securities Data. That’s a record, topping 1998, the previous record year, when $1.63 trillion in deals were reported.

The question is: How can an individual investor make money from the trend?

There’s always chance — the chance of owning a company that gets acquired for more than its stock is trading for. That’s what happened to Honeywell International(HON) investors earlier this year, when General Electric(GE) agreed to pay a 20% premium for Honeywell shares.

Some professional value investors do look for stocks that they think would make good takeover targets. But that’s a long-shot way to make money. “It takes inside information or a very good hunch to predict when one company will buy another,” says Greg Ringhahl, a certified financial planner in Lantana, Fla. “A deal will still need regulatory approval, and the stock of the company that will be acquired usually has to increase for you to make money.”

Given those odds, perhaps the best way for individual investors to play the M&A game is through mutual funds. M&A funds do not try to catch the rising stock of a potential takeover target. Rather, they invest in companies after a takeover announcement and make money from stock swaps and other deals.

These funds come in after a deal is announced and take advantage of the disparity between the stock price of the acquiring company and its acquisition target, says Michael Gaul, a fund analyst at Morningstar. Investing in these funds can be a good market-neutral strategy, he adds, as the funds depend not on market movements but on merger and acquisition deals that happen in both good and bad markets.

Roy Behren, an analyst for Westchester Capital Management in Valhalla, N.Y., which manages the (MERFX)Merger Fund, says times are good for investing in these deals. As opposed to the ’80s, when many of the deals were financially driven, a larger portion of today’s deals are strategic and so are much less likely to unravel, he says. Indeed, few announced mergers in which the fund has invested — including the US West-Qwest merger in which the fund took advantage of a temporary widening of the spread caused by fears that Deutsche Telekom would scuttle the deal — have derailed, and that has worked in the fund’s favor, according to Morningstar.

The Merger Fund’s managers, Frederick Green and Bonnie Smith, evaluate the various mergers announced and decide which have the best chances of success, strategywise. They then buy the stock of the company that will be acquired and short the acquirer’s stock.

If a deal closes, the fund makes money; if the deal is called off, the fund takes a loss, Behren says. When a deal goes wrong, the managers will take the position off right away and take a loss, he adds, but points out that more than 90% of the deals the fund invests in close.

This year, the fund participated in VoiceStream’s(VSTR) acquisition of Omnipoint because VoiceStream was already an investor in Omnipoint, but it avoided Viacom’s(VIA) merger with CBS, as CBS was already trading at the price Viacom offered for it.

Like other funds of its kind, the Merger Fund, which is closed to new investors, does not look for whopping returns but aims for a 12% annualized return and minimum volatility. As of Oct. 31, the fund had a 12.7% 10-year annualized return according to Morningstar.

Other funds that are open to new investors have adopted a similar investment strategy, including the tiny $3.6 million Deutsche Quantitative Equity fund, which was up 8.4% for the 12 months ending Oct. 31, according to Morningstar.

The same goes for the (GABCX)Gabelli ABC Fund, which was up 10% annually for the past five years on Oct. 31, according to Morningstar.

Manager Mario Gabelli looks for announced mergers, then tries to buy the target company at a discount to the announced purchase price. Gabelli aims to gain by selling stock in the target company when the price gap closes. And, like other funds of its kind, the ABC Fund unwinds its position in a bad deal.

So are there more mergers to come to feed these funds? David Yeske, a financial planner at Yeske &Co. in San Francisco, believes so. “If you look at the history of acquisitions, they tend to happen in clusters,” he says. “You need to ask if the company that acquired the original company looks for additional acquisition targets. Or will its competitors think they need to take over more companies to keep up with the original acquirer?”

Areas of the greatest activity are networking and telecom firms, says Yeske. “Cisco and Nortel, for example, are continuously trying to one-up each other — both firms making multiple acquisitions every year,” he says, but adds that for some companies, squashed stock prices might be an indication of dampened enthusiasm for more M&A activity: “The telcos were bulking up through takeovers until their shares started cratering, and AT&T, WorldCom, Sprint, SBC and Verizon all fall into this group.”

Still, whatever the future for M&A activity, returns of 8% to 12% sure beat what this market has been serving up lately.