How to play mergers and acquisitions

Mergers and acquisitions often leave shareholders worse off. But you can still profit from them. Tim Bennett explains how.

Warren Buffett isn't happy. The famed investor owns 9.4% of US food giant Kraft Foods and reckons Kraft's takeover of UK confectioner Cadbury is a "bad deal". He has good reason to be nervous. Mergers and acquisitions (M&A) often leave shareholders worse off. But you can still profit from them here's how.

What is a merger or acquisition?

Kraft is buying Cadbury with a mixture of cash and shares worth £11.9bn. This will enable Kraft to take total control of the brand by buying the majority of Cadbury's voting shares. A common alternative is a merger, where two groups of shareholders agree to combine their firms. Each group swaps its shares for a stake in the newly-merged entity and retains voting rights afterwards.

Mergers require agreement and so are 'friendly'. A takeover can be friendly too the target's directors and shareholders may be open to the idea. But if the target is an unwilling victim, the deal may turn 'hostile'. The final decision to accept or reject a bid rests with the target's shareholders. To succeed, at least 50% plus one must agree to sell their shares.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

What's the point of M&A?

One way for a firm to grow is through 'organic growth' making profits and re-investing them in the business. But a quicker way is to buy, or merge with, another firm. M&A has other benefits too. By buying a rival, a firm can expand what Buffett calls its 'economic moat'. The merged firm is harder for anyone else to compete with or buy out.

Acquisitions may also create 'synergies' and 'economies of scale'. By uniting similar product lines, for example, an enlarged firm may cut competition for its products and raise profits. Areas such as research and development or marketing can join forces to develop new and better products. The bigger firm may also cut costs purchasing, personnel and accounts ('back office' costs) are classic candidates. And a larger predator will often claim that it brings in a stronger management team and brand.

That's the theory anyway. The trouble is, as The Economist notes, studies show that "three-quarters of mergers fail to create any shareholder value and half actually destroy it". For example, says Jeremy Warner in The Daily Telegraph, RBS's takeover of ABN Amro "delivered little more than a pile of bad debts".

Why M&A fails

"Most mega-mergers are more the result of executive boredom, delusions of grandeur and the siren call of fee-hungry investment bankers than compelling industrial logic," says Warner. Take fees advisers on the Kraft/Cadbury deal will have made around $390m and counting, according to the Financial Times.

Then there are problems with digesting the deal. Senior management can quickly fall out over how a firm is run. Cross-border cultural differences can cause trouble too. The UK has different laws, business practices, brand loyalties and management styles to the US, for example. That's one reason so many UK brands from Bodyshop to M&S have floundered on the other side of the Atlantic. Senior executives may also lose interest in the slog of integrating a new firm they'd rather focus on the next exciting deal.

How to make money from M&A

But you don't have to believe in the logic behind a deal to profit from it. Generally, in a bid, owners of the predator worry about overpaying, sending the share price down, while investors get excited about further bids for the target, pushing the price up. So if you expect a bid, you can buy the target (either via its shares or by using a 'long' spread bet) and sell the predator (using a 'short' spread bet). If a deal is announced, and the predator's share price duly falls and the target's rises, each leg will make a profit. As Riccardo Marzi explains in the Events Trader newsletter, you should commit the same amount of cash to both legs of the trade so that your strategy is 'market-neutral'. In other words, if you're right about the deal, you make money whether the broader market rises or falls. Of course, if you believe the Cadbury deal will benefit Kraft's shareholders, you could just buy Kraft shares. But we wouldn't (see below).

Why Kraft is a sell

Kraft's recent track record is not great the stock has fallen around 8% since it split from Philip Morris in 2001. And this weak performance looks set to continue. As The Economist notes, the takeover of Cadbury should in theory 'bring better management to Britain'. But 'Cadbury is itself a multinational and in no need of lessons from Kraft'. And given the likely friction involved in merging two different cultures, Warner sees only one result: 'a steady loss of international market share to the likes of Nestl'. So despite the 4% dividend yield, we'd give the stock a miss. As for Cadbury's shareholders who end up with Kraft shares, we'd suggest selling when you get them.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.