Investing is a hard business. You can't take anything for granted, and there is no easy and fast formula to predict how well a stock will do.
It's hard to determine whether a company -- even a leader in a steady-as-it-goes business -- will continue to deliver profits or appreciate versus the competition.
Case in point: Kraft Heinz (Nasdaq: KHC). This consumer-staple company has turned out to be anything but safe and steady.
You've likely heard by now that shares of the world's fifth-largest food-and-drinks company lost 27% in a single session on Friday, February 22. And Kraft halved its dividend, too. A whopping $15.4 billion write-down of its acquisitions of Kraft and Oscar Mayer was just part of the bad news; the company also disclosed a U.S. Securities and Exchange Commission (SEC) investigation of its procurement accounting practices.
Talk about risky...
Before that one-day nosedive, KHC had already lost about half of its value. And now, even Warren Buffett, arguably the best investor in the business, laments that he overpaid for Kraft (Berkshire Hathaway owns 26.7% of the company and lost more than $4.3 billion on that fateful Friday).
(This article from CNBC gives a pretty good rundown of how Buffett's investment in the deal fell apart.)
All of this poses a question: If even Warren Buffett is capable of making this kind of mistake, then what are we to do about it as investors?
We'll get to that in a second. But first, let's discuss the basic mechanics of a takeover...
How Takeovers Work
Naturally, it is also next to impossible to predict whether a company -- any company -- is likely to be taken over. There are too many factors involved in any takeover decision, and the appeal of a target business (or product) is just one of them. Just as important to a final decision are the price this possible takeover candidate would demand, the financial wherewithal of the acquirer, possible synergies and cost savings of the combined company, and the risk-taking abilities of a possible acquirer, to name just a few.
The price premium over the target's price, which is typical for a takeover, reflects the fact that an acquirer does not want to deal with a competing bid and wants to make the offer too good for shareholders to refuse. And because nobody can see the future, even the insiders -- those who initiate the deal -- can underestimate the potential merger benefits or simply overpay.
In the Kraft case, for one, the write-off (one of the largest ever) is related to past acquisitions: the company wrote off $7.1 billion in the U.S. Refrigerated and Canada Retail unit and $8.3 billion for the Kraft and Oscar Mayer intangible assets. It's never a given that the price paid for a takeover target will be worth it.
What Can We Learn?
Now back to our question... What can we learn from this?
Well, we know that even for M&A deals that may have been discussed or telegraphed in advance, a large premium is rather typical. And that possibility, of course, is pretty enticing to the average investor.
That's especially true in the high-risk biotech space we often target in my premium newsletter, Fast-Track Millionaire. Premiums for these deals often exceed 50% and can be as high as 100% or more.
But most investors shouldn't put their money to work based solely on news (or rumors) of a takeover. After all, if Buffett was intimately familiar with the Kraft Heinz deal and still got it wrong, then investors would be unwise to think they can do better with less information.
Is investing in biotech risky? You bet.
Dozens, if not hundreds of small and mid-sized biotechs trade not so much on the promise of their future earnings as on the potential value of their drug discoveries.
But by diversifying and by carefully accessing the risks of each stock versus the potential for outsized returns in case of a large win, these are risks that can be managed. Plus, for individual investors like us over at Fast-Track Millionaire, whose goal is to outperform the market, biotech is the ultimate growth sector. With its risks and outsized return potential -- it is a sector not to be ignored.
(This article originally appeared on StreetAuthority.com.)