How Does a 36% Annualized Return Sound?

Can investors earn a 36% annualized return by investing in a basket of 22 stocks that are the object of pending leveraged buyouts (LBOs)?

That what Goldman Sachs Chief U.S. Sector Investment Strategist David Kostin suggested in a July 27 report -- assuming all the deals close at current terms and dates estimated by Goldman. Such fat returns are a result of the widening of risk (or merger) arbitrage spreads -- the difference between a stock's current market price and the price the acquirer is offering to pay -- due to fears that the debt markets will no longer accommodate the LBO boom with the easy credit terms that have prevailed until recently.

The different stocks, of course, have different spreads, and the following tables highlight the three highest and three lowest expected annualized returns among the 29 pending LBOs announced or filed within the past six months.

 

Top 3 LBO stocks -- Expected annualized return

Target Last Closing Price
(8/10/2007)
Acquisition
Offer Price
Expected
Closing Date
Expected
Annualized Return*
Acxiom (Nasdaq: ACXM  ) $23.36 $27.10

10/15/2007

133%
Archstone-Smith (NYSE: ASN  ) $55.55 $60.75

10/5/2007

83%
SLM (NYSE: SLM  ) $48.20 $60.00 12/31/2007 76%

 Bottom 3 LBO stocks -- Expected annualized return

Target Last Closing Price
(8/10/2007)
Acquisition
Offer Price
Expected
Closing Date
Expected
Annualized Return*
Catalina Marketing (NYSE:POS) $31.52 $32.50 10/15/2007 19%
Alltel (NYSE:AT) $65.90 $71.50 2/15/2008 17%
Sequa (NYSE:SQA.A) $169.50 $175.00 11/15/2007 13%
Source: Standard & Poor's Capital IQ. Expected closing dates: Dow Jones, Motley Fool research.
*Does not include any dividend payments.

What's more, according to my research, the situation for prospective investors has gotten even better since Goldman's report. Since equity prices are lower than they were just a few weeks ago, investors can now expect a 46% annualized return by buying the stocks poised to be bought out.

It's all fun and games until the deal falls through
Not so fast. Risk arbitrage is a sophisticated form of speculation. It essentially means making informed bets on whether or not announced M&A transactions will be completed at the announced prices.

While arbitrage is risk-free by definition in academic finance, real-world finance shows that the spread between current stock price and offer price isn't a free lunch. The fundamental risk the arbitrageur faces is the possibility that the acquisition doesn't go through, which can happen for any number of reasons (financial, regulatory, etc.). If the deal collapses, the arbitrageur will find the only thing free about this lunch is a painful indigestion, as the price of the target company may fall back to the levels at which it was trading prior to the original deal announcement.

As a result, even though the returns in the tables above look alluring, I'd recommend individual investors avoid betting on mergers -- merger arbitrage professionals have an enormous advantage in terms of time, resources, and diversification.

Think probabilistically
Still, individual investors can take a lesson from arbitrage pros such as Warren Buffett and Eddie Lampert and think probabilistically. Whether you are investing in a business or betting on a merger, expected returns are never guaranteed -- risk-adjusted returns should be your standard.

Understanding that different scenarios can develop from a set of initial conditions and being able to quantify the payoff and odds associated with each of them is a key discipline. Bill Miller, the manager of Legg Mason Value Trust (LMVTX), had his team go through this process explicitly in valuing Amazon.com (Nasdaq: AMZN  ) . The effort has paid off handsomely -- the stock is up more than 90% this year.

This is the mode of thinking we strive to emulate at Motley Fool Inside Value and it is what led us to recommend selling First Data on June 21 -- after it had received a $34 bid by LBO firm Kohlberg Kravis Roberts & Co. We wrote, "While we believe the probability that the acquisition will fall through is small, we don't think the extra 4.6% return you can earn by holding on to the shares is sufficient incentive when you can capture most of KKR's generous bid premium by selling them now."

Since then, the spread between First Data's stock price and KKR's offer price has increased rather than narrowed.

What to do next
As for the prospect for risk arbitrage profits going forward, it's perhaps not too fanciful to refer back to Warren Buffett's writing during the merger boom of 1988:

Some extraordinary excesses have developed in the takeover field. ... We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. ... We have no desire to arbitrage transactions that reflect the unbridled -- and, in our view, often unwarranted -- optimism of both buyers and lenders. In our activities, we will heed the wisdom of Herb Stein: 'If something can't go on forever, it will end.'

While the prospect for risk arbitrage profits may be diminished, the current market volatility has created some tremendous opportunities for value investors. We've just selected our best ideas in the Annual Review issue of Motley Fool Inside Value -- to find out what they are, click here to join our service free for 30 days. There's no obligation to subscribe.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Amazon.com is a Motley Fool Stock Advisor recommendation. The Motley Fool has a disclosure policy.


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