Profiting from Rising M&A Activity

Mergers and acquisitions are perking up across sectors as confidence in the economy improves. With enterprise price tags relatively low and private equity firms shut out, corporations with access to capital are making strategic acquisitions to bolster their competitive positions.

Just last week, Agilent Technologies (A) agreed to buy Varian for $1.5 billion. Also in the technology space, International Business Machines (IBM) agreed to buy Chicago-based predictive analysis software provider SPSS (SPSS) for $1.2 billion.

In the health care sector, France's Sanofi Aventis (SNY) is forking out $4 billion to Merck (MRK) to take full-control of its 50-50 animal health joint venture Merial. Sanofi is also buying India-based vaccine maker Shantha Biotechnics for $781 million.

In energy, pipeline operator Targa Resources Partners (NGLS) is acquiring the natural gas liquids business of Targa Resources for $530 million. Wireless services provider Sprint Nextel (S) is buying Virgin Mobile USA (VM) for $420 million. In airlines, Southwest Airlines (LUV) has entered the ring with the intent of trumping Republic Airways (RJET) and acquiring distressed carrier Frontier Airlines (FRNTQ.PK).

The increase in the number of mergers and acquisitions is providing investors unique ways to profit from such activities.

Profiting from Mergers and Acquisitions

One way to profit from rising M&A activity is to take long positions in potential targets. The second way is to capture the spread between the final price paid by the acquirer for the takeover target and the prevailing market price for the target. This spread arises because the target's shares often trade at a discount to the offer price. The magnitude of the spread depends on factors such as uncertainty associated with the deal, interest rates, and investor risk appetite. The above two methods are usually better suited for institutional investors.

A less common, yet effective way for retail investors to profit from the M&A action, is by purchasing shares of investment banks that can profit from rising mergers and acquisitions. Goldman Sachs (GS) and Morgan Stanley (MS) are examples of independently traded investment banks in the U. S. These firms along with European banks like Credit Suisse Group (CS), and Deutsche Bank (DB) have deep expertise in sectors like health care and geographic regions like Asia both of which promise heightened M&A activity.

The credit crisis has also enabled certain commercial banks to bolster their investment banking capabilities. Bank of America (BAC), JP Morgan Chase (JPM), and Wells Fargo (WFC) are relatively well-positioned to derive a material portion of their profits from mergers and acquisitions. However, exposure to residential and commercial real estate can adversely impact the share price performance of these banks.

Mutual Fund and ETF Investors

Investors looking for bundled products that can benefit from mergers and acquisitions have a few pickings to choose from.

In the mutual fund space there is Fidelity Select Brokerage & Investment Management (FSLBX) and The Merger Fund (MERFX).

FSLBX is more of a conventional vehicle that focuses on investment banks, asset managers, and exchanges. MERFX is somewhat unconventional in that it seeks to profit from the arbitrage spreads.

ETF investors can look at SPDR KBW Capital Markets (KCE), iShares Dow Jones US Broker-Dealers (IAI), and Claymore/Clear Global Exchanges, Brokers & Asset Managers (EXB). While KCE and IAI do not include foreign companies, EXB invests in firms from around the globe.

In 2009, all of the above investments except MERFX have handily outperformed the S&P 500. MERFX has gained about half as much as the S&P 500 with much less volatility than the benchmark.