Stop Buying the Rumor

My Foolish colleagues Brian Richards and Tim Hanson wrote an excellent article about how following the old adage, "buy the rumor, sell the news," can incinerate your portfolio.

Alas, it looks like a lot of people weren't paying attention.

Last week, two companies that were the subject of buyout rumors saw their stocks rise dramatically, only to fall as the buyouts failed to pan out.

Company	Rumored Suitor	Rise From Pre-Rumor Close	Fall From High Through Aug. 28
Human Genome Sciences (Nasdaq: HGSI  )	GlaxoSmithKline (NYSE: GSK  )	32.6%	(13.1%)
Viropharma	Teva Pharmaceuticals (Nasdaq: TEVA  )	6.7%	(6.1%)

Source: Yahoo! Finance.

For those who bought into the rumors at their height, those are some pretty painful falls, especially over the two days after the rumors were refuted.

Every industry is subject to chitchat about buyouts -- Microsoft (Nasdaq: MSFT  ) was rumored to be eyeing Chinese SINA (Nasdaq: SINA  ) a few months back -- but the biotech-pharma relationship, complete with a history of M&A deals in the industry, seems especially ripe to rumors. The story can be magnified when you get a very plausible-sounding rumor, such as Glaxo buying its partner, Human Genome Sciences.

Sure, there are exceptions. The Wall Street Journal's report that Pfizer (NYSE: PFE  ) was in talks to take out Wyeth turned out to be true, but even that didn't pan out all that well for investors who weren't on their toes. The Monday after the announcement was made, Wyeth's stock closed lower than the previous Friday, when the rumor mill was still churning.

The problem with buying on the rumor is that you're basically gambling. There's no real way to know if the rumor is true -- even if it's printed in a newspaper.

What the heck?
After an article I wrote about Novartis (NYSE: NVS  ) potentially buying Elan, a reader seemed just as puzzled about the flurry of rumors -- this was the third or fourth involving Elan -- and sent me an e-mail wondering about the article in the London's Sunday Times to which I had referred. Here's his laundry list of well-thought-out questions:

Exactly who are these "well placed sources?"

They're most likely high-level management. Companies try to keep these things under wraps in order to avoid insider trading issues.

Could I tell you personally, but anonymously, that I have information regarding a potential deal, and you would write a story?

At The Motley Fool, we have a strict policy: If you don't go on the record, we won't publish it. You'll never see us talking about people who asked not to be named. For other sources, I think you've got to consider the reputation of the publication. Some penny-stock-touting newsletter might run with your rumor, but I doubt The Wall Street Journal would want to talk with you.

Does the writer guarantee the credibility of the sources?

Indirectly, yes. If a publication gets enough rumors wrong, investors will stop reading it. Of course, given many investors' propensity to latch on to "news" that's less than verified, I may be a tad optimistic about the negative implications of consistently getting it wrong.

During the negotiation process, why would someone who knows the details leak the information to the media? 

It might be that the company thinks releasing the information might get the deal done, or maybe get other companies interested. It's also possible that the source isn't even acting on the company's behalf, and just gets a kick out of being an inside source.

Isn't that disseminating inside information?
As far as I know, not being a lawyer, spreading inside information may be stupid and a bad business practice, but it isn't illegal unless you're trying to profit from it.

Don't be that guy/gal
Investing is about analyzing data and making sound decisions, not making rash choices based on rumors. Sure, you might be able to make a quick buck if the rumor proves true, but it's also a good way to lose your shirt, or at least a sleeve, as I showed above. If you need a little help finding and analyzing companies, we've got plenty of newsletters to aid you, but please don't confuse investing with gambling. In the long term, only the house wins with the latter.