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Published: October 1, 2009
We all watched in anguish as the S&P 500 dropped
-40% from October 2008 to March 2009. Even the most diversified
portfolios weren't immune.
For all the talk about foreign economies being "decoupled" from
the U.S. economy, foreign stocks tumbled in lock step with ours.
Bonds fell. Preferred stocks fell. Aside from Treasuries and
funds designed to short the market, it seemed like nothing was
safe from the carnage.
But two unique equity funds held their ground. And this was no
fluke. These two funds employ a strategy that ignores market
conditions and appreciates even in the worst of times.
As you can see from the chart below, they barely broke stride
during the last year's onslaught.
The Merger Fund (MERFX) and The Arbitrage Fund (ARBFX)
are equity funds that invest primarily in companies that are
being acquired. To purchase a company, the acquiring company
usually has to pay a premium. Ernst and Young state that the
average takeover premium in the U.S. over the long run is around
+24%.
When a bid for a company is first announced, the company's stock
rises, approaching the premium bid price. It approaches it --
but usually doesn't reach the bid price. After all, there is
still a small, but finite, possibility that the deal will fail
to close.
Merger-arbitrage funds like MERFX and ARBFX buy the shares of
acquisition targets below the bid price and ride the rest of the
way up until the deal is finalized -- making a small percentage
off each deal. The more merger and acquisition (M&A) deals that
are done, the more money they make.
One notable casualty of the
financial crisis was the number of
mergers, acquisitions and private
equity deals. There were far fewer
lenders willing and able to finance
takeovers, and only the largest
cash-rich companies could pull off
acquisitions of any size.
Globally, the total value of M&A
deals announced in 2007 was $4.4
trillion -- up from $3.8 trillion in
2006 (the previous record) and more
than triple the deals done in 2003.
But in the second half of 2008, M&A
deals all but disappeared and the
the global M&A market shrank to less
than $2.5 trillion for the year.
But that is changing.
Enter Merger-mania
Companies have repaired their
balance sheets and are looking to
score a deal. More credit is
available and there is a lot of pent
up demand that appears to be
breaking loose. Every Monday, there
seems to be a slew of new M&A
announcements. This week it was the
drug maker Abbott Laboratories
(NYSE: ABT) buying a unit of
Solvay. And Xerox (NYSE: XRX)
announced its agreement to buy
Affiliated Computer Services (NYSE:
ACS).
A few weeks ago, Warner Chilcott
(Nasdaq: WCRX) agreed to buy
Proctor & Gamble's (NYSE: PG)
drug business. Dell (Nasdaq:
DELL) offered to buy Perot
Systems (NYSE: PER). And
Kraft (NYSE: KFT) is still
tussling with an unsolicited bid for
Cadbury (NYSE: CBY).
So even if that market correction
never comes (fingers crossed), it
looks like merger-arbitrage funds
may be heading into a very lucrative
period. (To read about another way
to profit from the M&A boom, go
here.)
Merger-arbitrage funds have sizable
costs because of the amount of
turnover in the funds. As a result,
their expense ratios are higher than
most investors are used to --
between 1.5% and 2.0%. Also because
they hold securities for relatively
short periods of time, they throw
off a lot of short-term capital
gains. So they are best held in a
tax-deferred or tax-free account.
But these seem like relatively small
inconveniences for investments that
have proven track records in market
downturns and appear to be heading
for higher ground.
-- Amy Calistri
Editor
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