This Just In: Banker Says to Buy EMC and SanDisk

Dell is buying EMC (EMC). Western Digital (WDC 4.28%) will buy SanDisk (NASDAQ: SNDK) -- and you should, too.

At least, that's what Mizuho Securities says.

In a pair of big upgrades Thursday, the Tokyo-based banker endorsed buying both EMC and SanDisk. And yet, Mizuho made a curious case: According to the banker, neither EMC nor SanDisk are particularly good companies, but they could still turn out to be very good investments today. Let's begin at the beginning.

EMC
Mizuho says "there are no fundamental reasons to get involved" in EMC stock today. And given that EMC just reported annual results showing revenue basically flatlined, while profits plunged 27%, many investors may be inclined to agree.

On the other hand, Dell has promised to acquire EMC in a cash-and-stock transaction recently valued at $67 billion. Given that the entirety of EMC as an enterprise currently costs only $46.1 billion, it's arguable that a buyer today stands to make about a 45% profit when Dell's acquisition goes through. As StreetInsider.com reports, Mizuho says this discrepancy between current price, and buyout price, has "likely created an opportunity" for investors to make a quick profit on EMC stock.

SanDisk
The argument in favor of buying SanDisk is similar. Between "slowing handsets and retail (combined ~70% of revenues)," Mizuho sees multiple reasons not to want to own SanDisk shares today. And yet, Western Digital does want to own SanDisk.

Indeed, Western Digital has bid $86.50 a share to acquire the flash memory maker -- $20 more than SanDisk shares fetch on the open market today. To Mizuho's mind, this creates yet another "arbitrage opportunity" for opportunistic investors to buy low today, secure in the knowledge that they can sell high when Western Digital closes its acquisition a bit later on.

So these are pretty basic, obvious arguments, right? If you know for certain that a deal is about to close, and that you can earn a 45% profit (in the case of EMC) or a 31% profit (with SanDisk), then why not take the free money?

Let's go to the tape
Here's one possible reason not to: Mizuho's argument may sound convincing, but Mizuho is very often wrong.

At Motley Fool CAPS, we've been tracking Mizuho's performance as a stock picker for about four years now, and what we've seen so far is not encouraging. Overall and on average, only about 40% of Mizuho's stock recommendations have beaten the market historically (that's a 60% record for failure). And on average, folks following Mizuho's recommendations these past years have underperformed the stock market by about 10 percentage points per pick.

A few notable, and scary, examples:

Gauging the risk
And we'd be remiss in not pointing out that Mizuho has also been wrong about EMC before. Recommending that investors buy shares in the data storage specialist in April 2012, Mizuho went on to underperform the market by more than 50 percentage points with that pick.

Meanwhile at SanDisk, my Foolish colleague Sam Mattera recently pointed out that while acquisitions like the ones Mizuho bases its buying on are expected to proceed as planned, they may not. Sam reminds us that "back in September, China's Unisplendour Corporation announced that it would acquire about 15% of Western Digital. The proceeds from the deal would go toward strengthening Western Digital's balance sheet, and ultimately allow it to acquire SanDisk."

First, however, "the Committee on Foreign Investment in the United States (CFIUS) needs to approve the Unisplendour deal." It may decide not to, and so there's at least the possibility that a negative decision by CFIUS could derail the SanDisk deal, and evaporate the potential for profits there.

How to stay safe when arbitraging
Given the risk that an obvious investment in EMC or SanDisk may become less obvious due to unexpected risks, what can an investor do to help mitigate those risks? Well, it never hurts to run a quick valuation, and determine whether, in the unlikely event a deal doesn't go through, you'd still be happy to own the stock even if it doesn't get bought out. So let's do that:

Valued at $13.3 billion today, and generating $633 million in annual free cash flow (according to S&P Capital IQ data), SanDisk shares look a bit pricey at 21 times free cash flow. In contrast, EMC shares sell for just 10.4 times free cash flow, which looks to me like a fair price to pay based on their 10% projected earnings growth rate and 1.9% dividend yield. In any case, it's a whole lot cheaper than SanDisk, and that in and of itself is a risk mitigator.

A second factor to consider: In addition to having less downside risk, EMC's acquisition by Dell looks to have more profit potential than SanDisk's acquisition by Western Digital. Simply put, 45% profit is better than 31% -- and that's another vote in favor of buying EMC over SanDisk.

Put these two rationales together, and while I generally agree with Mizuho that both SanDisk and EMC make for intriguing arbitrage opportunities, EMC is just a wee bit more attractive.