Why an M&A Surge Could Hurt the Dow Jones Industrials

Mergers and acquisitions are usually seen as positive for stocks, but the Dow might not be so lucky.

Apr 29, 2014 at 12:30PM

The Dow Jones Industrials (DJINDICES:^DJI) was up 95 points at 12:30 p.m. EDT, approaching its best level of the day. The Dow largely ignored a slight drop in consumer confidence and some signs of weakness in the housing market, as a relatively solid earnings season continued to bolster investors' beliefs about the sustainability of the bull market. Yet Pfizer (NYSE:PFE) missed out on the gain, falling 1.1%; its decline points to some of the potential downsides of a rise in merger and acquisition activity that has spread across the market recently.

The pros and cons of M&A
Most of the time, M&A activity is a positive for stocks, as the prospects of a company becoming a takeover target leads to optimistic speculation among investors. Moreover, an actual takeover bid can be positive not just for the target company but for other companies in the same industry, as investors infer that what makes one particular player in a sector enticing could well be attractive to other players in that sector as well.

But as lucrative as M&A can be for shareholders of target companies, the impact on the acquirer is often less certain. For instance, Pfizer shares initially rose when it announced its pursuit of AstraZeneca (NYSE:AZN), which had begun in January and which Pfizer sought to restart over the weekend. Yet today, Pfizer shares are down as investors realize that the pharma giant likely will have to increase its bid in order to persuade AstraZeneca to accept a merger.

In this case, the benefits for Pfizer are relatively clear. Not only does it get access to AstraZeneca's drug pipeline, but it also gets a tailor-made opportunity to move its tax domicile out of the U.S. and thereby potentially reduce its tax expense dramatically. In order to reap the tax benefits of a move, there's a limit to how much cash Pfizer can offer in a transaction, but Pfizer can issue more shares and still comply with current laws on domicile.

Yet typically, shares of the companies that seek to buy out acquisition targets end up falling. That happens for a variety of reasons, including shareholder dilution when the acquirer uses stock for the acquisition. But most often, the perception that the acquirer is overpaying for the target company drives shares of the acquirer lower. It takes a deal like Pfizer's, which the drugmaker argues will be accretive to earnings within the first year after a merger, to send shares of both the acquirer and the target higher simultaneously.

Because of their size, the 30 companies in the Dow Jones Industrials will almost always be acquirers rather than targets. As such, Dow members will have to be careful in their M&A planning to make sure they don't pay too much in the race to make the right strategic match. Otherwise, paying billions for a target company could turn out to be a wasted opportunity.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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