Hulbert - Stocks are ‘Dangerously Overvalued,’ M&A Deals Suggest

Analysis: Every big wave of mergers has ended with a drop in equities…

Mark Hulbert writes for Dow Jones MarketWatch:  Here’s one sign a significant stock market decline might occur sooner rather than later: the rapid acceleration of recent merger and acquisition activity.                                         

This past week saw news of another big deal, led by medical-device maker Medtronic’s announcement of its $43 billion bid to acquire rival Covidien.                                                                        

At the current pace, M&A deals could reach $3.51 trillion this year, the most since 2007, according to data provider Dealogic.

It wasn’t a fluke that a surge in M&A activity coincided with that year’s market top, according to Matthew Rhodes-Kropf, a professor at Harvard Business School and an expert in the field. “Each of the last five great merger waves on record” — going back more than 125 years — “ended with a precipitous decline in equity prices,” he says.  (Continued…)    

Some experts have found that merger activity surges when stocks are richly priced, at least in part because companies can use their inflated shares to pursue acquisitions.

Medtronic has offered $43 billion to buy Covidien, a medical-device competitor.  (Image Bloomberg)

“The marked increase in recent M&A activity is one more piece of evidence that the market is dangerously overvalued,” says Dennis Mueller, an emeritus economics professor at the University of Vienna in Austria who has studied M&A cycles in the U.S. as well as overseas.                                        

Of course, shareholders of the company being acquired rarely complain, since the acquisition price usually represents a huge premium. Covidien’s stock this past week surged as much as 29%, compared with where it closed the prior week, for example.                                        

Does the recent M&A boom mean you should immediately get out of stocks? Not necessarily, since the volume of M&A activity isn’t an exact market-timing tool.                                        

Mueller says it’s possible that the market is at the beginning of a long M&A boom that could last a few more years.                                        

Rhodes-Kropf agrees that the recent M&A surge doesn’t necessarily mean a bear market is imminent. “Everyone tends to call the bubble too soon,” he says, adding that his hunch is that this merger trend could very well last a while longer.                                         

‘Risk arbitrage’                                         

So can you make money from the increased M&A activity while this lasts? One strategy for doing so is known as “risk arbitrage” or “merger arbitrage.” It exploits the price difference that usually exists immediately after a merger deal is announced between the price at which the acquired company’s stock is trading and its eventual takeover price.                                        

Covidien’s stock, for example, trades at a 6.4% discount to the price at which Medtronic says it will acquire the company later this year or early next year. By buying the stock now, and assuming the deal is completed under the same terms as announced earlier this week, you could profit from the discount.                                        

Risk arbitrage is more the province of hedge funds than individual investors. If you’re a so-called accredited investor — which the Securities and Exchange Commission defines as an individual whose annual income tops $200,000 or whose net worth exceeds $1 million, excluding a primary residence — then you are allowed to invest in a risk-arbitrage hedge fund.

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According to hedge-fund tracker HFR, the merger-arbitrage hedge-fund category gained 3.9% over the 12 months ended May 31. Though that’s far behind the 20% return of the S&P 500 over that period, it’s an unfair comparison because funds in this category aren’t designed to beat the market.                                        

Instead, investment research firm Morningstar compares merger-arbitrage strategies to a “market-neutral” benchmark, which historically has produced returns only slightly higher than a money-market fund. Over the 12 months ended May 31, this benchmark gained 1.1%.                                         

If you’re not an accredited investor, your opportunities are probably limited to several mutual funds that focus on risk arbitrage. Invest only a small portion of your portfolio in any of them, of course. And rather than sell any of your stock holdings to buy these funds, you should consider them as substitutes for your cash or short-term bond holdings.                                        

Two exchange traded funds in this category are IQ Merger Arbitrage, which charges annual fees of 0.77%, or $77 per $10,000 invested; and ProShares Merger, with fees of 0.75%. Both ETFs attempt to match an index reflecting all recently announced deals, with the ProShares ETF focusing only on U.S. mergers while the IQ fund also includes global deals. The IQ ETF has returned 6.2% over the past 12 months, while the ProShares ETF has lost 1.3%                                        

The actively managed Merger Fund  charges 1.26%; its performance reflects both the returns of pure risk arbitrage and the judgment of its managers. It’s gained 5.1% over the past 12 months.                                        

Takeover targets                                         

A riskier strategy for exploiting the M&A boom is to guess which companies will be eventually taken over. If you’re right, you can capture a quick short-term profit when the takeover is announced.                                        

There is no surefire way of predicting which companies will be takeover targets. Perhaps the best strategy is to identify highly profitable and growing companies that are nevertheless selling at a big discount to comparable firms. There’s relatively little downside to buying a basket of such companies, since even if none is taken over you still will be acquiring good-quality companies at cheap prices.                                        

The most important takeaway from the recent pickup in M&A activity, however, is caution, according to hedge-fund manager Douglas Kass, president of Seabreeze Partners Management. “Heightened M&A activity is more consistent with market tops than market bottoms,” he says.                                        

Mark Hulbert is editor of the Hulbert Financial Digest, which is owned by MarketWatch/Dow Jones. Email: [email protected]                                        

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Mark Hulbert is the founder of Hulbert Financial Digest in Chapel Hill, N.C. He has been tracking the advice of more than 160 financial newsletters since 1980. Follow him on Twitter @MktwHulbert.

Source:  MarketWatch