The Best Way to Trade Market R

Last week, rumors were all over the news that online payments giant PayPal Holdings Inc. (PYPL, Financial) was in “late-stage talks” to acquire Pinterest Inc. (PINS, Financial) for $70 per share, valuing the image-based social media company at a more than 25% premium to its stock price at the time.

The majority of analysts expressed confusion about the merger, saying that PayPal was overpaying and that the companies had virtually no synergy. Alternatively, some thought the merger had potential, even if it would be expensive and risky.

However, none of that mattered in the end; as with many rumors, the PayPal-Pinterest merger turned out to be all talk. On Oct. 24, PayPal washed its hands of the gossip with a one-sentence official announcement that read, “In response to market rumors regarding a potential acquisition of Pinterest by PayPal, PayPal stated that it is not pursuing an acquisition of Pinterest at this time.”

Even though rumors aren’t always true, that doesn’t stop markets from reacting to them, especially when a well-known news source is the one spreading them. Investing in a stock before a value-accretive merger is completed can be quite lucrative, and so can taking advantage of an arbitrage opportunity. When there’s no way to be sure if the rumors are true, however, is investing in these stocks really worth the risk?

How to tell if the rumors are likely to come true

At first glance, it may seem like an impossible task to try and verify how likely acquisition rumors are to come true. After all, the only sources of information that most retail investors have access to are ones that the rest of the public also has access to.

It’s not really possible to get an idea based on who is reporting the rumors, either; in almost every case, news sites will quote some vague “sources familiar with the matter” or “those with inside knowledge of the matter.”

However, some news sites do have a better track record of reporting mergers and acquisitions than others. For example, approximately 80% of merger and acquisition rumors reported by Bloomberg have eventually become reality, compared to only 38% for the Wall Street Journal and 26% for Barron’s.

While it can be difficult to get a read on how likely a deal is to materialize, there is a rule of thumb that, while still inaccurate, is probably more accurate than many news sources, and that’s whether or not the stock price of the acquisition target is bid up to near or above the rumored acquisition price.

The fact of the matter is that compared to retail investors, most firms and hedge funds with billions of dollars worth of assets under management will typically have more inside knowledge on the M&A scene. That’s why a lot of the times, by the time the public finds out about an attractive merger opportunity, the merger will already be priced into the stock. If these big firms believe there’s a significant chance of a merger happening and being good for the companies, they will quickly jump on the opportunity with millions or even billions worth of capital, quickly closing the gap between the share price and the acquisition price.

For an example of this, we can look at how Pinterest never reached its rumored acquisition price of $70 per share, while Meredith (MDP, Financial) was quickly bid up above its rumored acquisition price of $56 once the gossip hit the headlines. Mere days later, it was announced by the companies that Meredith would indeed be acquired by InterActiveCorp (IAC, Financial).

Could shorting be safer?

According to a study conducted by Bloomberg between 2005 and 2010, only 14.5% of acquisition rumors turned out to be true. That same study found that, in general, shorting stocks that were the subject of acquisition rumors was a better strategy than buying them, since more likely than not, they would drop in price once the rumors were proven false.

However, this study has long been outdated. Since then, the percentage of acquisition rumors that turn out to be true has increased. Thus, shorting M&A rumors is more likely to result in breaking even or losing money.

Additionally, the stronger the bull market, the more likely we are to see high levels of M&A activity; with the current situation on Wall Street, it might not even be a stretch to say that where there’s a will to be acquired, there’s a company or a SPAC ready to pay a significant premium. The more companies that are waving cash around looking for an acquisition, the more likely deals are to happen, as evidenced by the fact that M&A activity has been 10% higher in 2021 that it has been at any point in U.S. history.

On the other hand, if you feel certain that a deal isn’t going to happen, or better yet, that the deal would be disastrous to the companies, short selling could be a viable option. Still, short selling in a bull market is risky and shouldn’t be done without a high level of conviction.

Focus on the long term

While astute investors might be able to find attractive investing or short-selling opportunities among rumors of potential mergers and acquisitions, the profits available from short-term positions remain relatively unattractive. If you had bought Meredith on its acquisition rumors, you might have earned 10% if you had gotten in early enough. Likewise, if you had shorted Pinterest last week, you might have pocketed up to a 13% return.

However, even if you had correctly guessed the veracity of these rumors, a return in the low double digits isn’t all that much considering the risks involved. Unless you had large amounts of capital to deploy with a high level of confidence, it wouldn’t have amounted to much dollar-wise. After a short-term trade, you’d also have to sell, book your profit and set aside your capital gains tax.

In comparison, focusing on the long-term potential of a company could be a better way to achieve more consistent gains with less risk. As Benjamin Graham famously wrote, “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

If the only way a company is going to continue growing in the future is through acquisitions, it might not be worth buying even if a rumored acquisition does come to pass, since the amount of capital required to keep up this business model is unsustainable (unless it’s a company like InterActiveCorp, which specializes in acquiring companies and bringing out their full potential).

On the other hand, if a rumored acquisition would be value-accretive for a company and drive its growth long into the future, it might be worth it to wait until the rumors are confirmed before buying the stock. It really depends on whether you think the company is worth buying without the acquisition or not. If the acquisition is the only reason why you would buy it, it could be better to wait, even if you have to buy the stock at a slightly higher price, in order to avoid the potential of the deal falling through and finding yourself the owner of a stock you don’t want.

The best kinds of companies to buy are the ones that don’t need acquisitions in order to be attractive buys, but which could benefit from combining with another quality business at the right price.

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