To trade takeovers, it is critical to understand how takeover bids work, to know as much as possible about the different players in the game, and to understand the specific details (including conditions) of the bid.
There are three main strategies to consider when investing in takeover scenarios.
1. Buying before a (potential) takeover bid
Although trading on potential takeovers does not strictly fall into the realm of takeovers, this is the most appropriate place to discuss the subject.
One must scour the market, looking for suspicious price activity. This is not easily defined, as it is a skill that people like The Rivkin Report investment team has developed over many years of stock market experience.
Put simply, one must look for what appears to be a strong accumulation of shares by a single party. Sometimes this is made easier by significant shareholders having to disclose their change of shareholdings. At other times, experts will just identify a particular accumulation pattern occurring in the market.
Next, one considers the fundamental value of the shares. This obviously involves examining the company’s fundamentals, such as NTA, P/E ratio, dividend yield and earnings, and so one may have to rely on experts for this information.
The next issue to consider is the company’s strategic value. Certain companies have strategic value, which competitors within a particular sector will fight for and, subsequently, often pay a high price for in the interests of securing a strategic asset and denying a competitor the chance to buy it.
So first of all, one must endeavour to identify price action that suggests some corporate activity may emerge. Then, to protect the downside, one must consider the fundamental value of the company and the strategic value. Armed with an understanding of these variables, a risk/reward ratio must be calculated. This allows one to decide if a share is good to buy, and if so, how much capital one should allocate to it.
This style of trading requires good timing and an excellent understanding of markets and the players in the markets. Few people can master this art without many years of study and practice.
2. Buying after the first takeover bid and then selling into a higher bid
One of The Rivkin Report’s most important rules is that ’it is very rare that the first price in a takeover bid is the last takeover price.’ This rule is essential to takeover investment strategy. This means that if you are selective, you can buy into a company that is under takeover and eventually sell into the final bid, higher than the initial bid.
Something to consider here is the rule to buy at, or close to, the first takeover price. This is a simple rule, but there is a bit more to it than just that.
There are two aspects to consider.
a. Quality or status of bidder
Make sure the bidder is a bona fide bidder. You should only get involved in a situation where the bidder is credible. The bigger the bidder is, the better their ability to pay up will be.
b. How many potential bidders could there be for the target?
As with the strategy of buying before a potential takeover bid, it is important to assess how many potential bidders there might be. Certain target companies have monopolistic characteristics that strategically may be very important to a number of companies.
One must make a basic assessment of the quality of the players and the strategic value of the target. Then, based on the price of the target, one must try to assess the upside/downside risk profile.
The downside risk of buying after the first takeover bid is the downside to the bid price. This bid price underpins the downside. The upside is up to you to assess.
The lesson is that when you see a takeover bid launched, examine the situation to assess the downside/upside risk profile. If the ratio is acceptable, the bidder is bona fide, and the capital is available, go for it.
There are two potential downsides to consider in regards to trading during this kind of takeover process. The first involves the likely downside risk if no other bids, beyond the first one, are launched. If one buys shares above the bid price in the hope that a higher bid will emerge, then the ‘likely’ downside is the gap between the price paid and the current bid. For example, if shares are bought at $1.03 when the current bid is set at $1, then the likely risk is 3c (plus transaction and holding costs).
The other type of risk to consider is ‘the worst-case scenario risk’. This is the downside likely to eventuate in the unlikely event that the current bid fails and no other bid is launched. This downside is not as easily predicted, but the share price levels in the period before the bid was launched are a reasonable guide.
While the odds of a bid failing completely are very low, it should always be considered. Although this rarely happens, it does occasionally.
3. Buying below the existing takeover price and making a guaranteed return
When the market believes another bid is unlikely, shares will often trade below the takeover price. This situation will often provide a low-risk, solid-return situation.
Three things to consider here are:
1. Never forget that even though the return provided by the bid at the time may be small in nominal terms, its annualised return is often much higher.
2. The chance of a higher bid can never be ruled out until the whole process is over, even if it seems unlikely. Often, when a friendly bid is launched, which the market expects to be successful, the bid will attract more corporate interest and a higher bid may appear. This has occurred on many occasions. This ‘free option’ over a higher bid should not be disregarded.
3. When trading this kind of takeover, where a further bid is unlikely and the nominal return is minimal, it is important to buy enough shares to make it worthwhile. Obviously, if you’re purchasing only $4000 worth of shares at 97c for a $1 bid, the 3.1% return won’t be worth it when you factor in brokerage and GST. Remember that one benefit when accepting a takeover bid is that you pay no brokerage and GST. Therefore, fees are only paid on the purchase.