By Spencer Israel
The market got hit with an unusual deluge of M&A news on the morning of Nov. 25.
Three major deals hit the tape—Charles Schwab’s $26 billion deal to acquire TD Ameritrade, Louis Vuitton’s $16 billion acquisition of Tiffany’s, and Novartis’ $9.7 billion acquisition of the Medicines Company—in what is typically a quieter part of the year for mergers and acquisitions.
As expected, the stocks on all six companies reacted to the headlines. But because these moves are nearly instantaneous, and all three deals had been rumored last week, there wasn’t much opportunity for traders looking to trade the news as they broke.
The Tiffany’s and Medicines Company deals are all-cash transactions, so the trading opportunity for those deals is over. Risk-arbitrage traders will keep both stocks trading at a slight discount to their takeout prices but barring the unlikely event that regulators express concern over anti-trust violations or a bidding war breaks out, the moves in the stocks have been made. Though neither deal is expected to close until 2020, TIF and MDCO are, for all intents and purposes, off the board.
There is, however, still an opportunity for relationship traders in the Charles Schwab-TD Ameritrade deal because of two key words: all-stock transaction.
All-stock transactions—when equity in an acquired company is swapped for equity in the acquiring company—are not as common as all-cash deals. But any deal that involves equity, be it an all-stock transaction or a cash and stock transaction, may create a long-term trading opportunity for traders willing to exploit relationship inefficiencies.
Here’s how it works. In equity deals, the acquiring and acquired companies will agree to a stock-for-stock swap based on a predetermined ratio. That ratio will then inform the market how much of a discount one stock should trade to the other. Shares of the two companies then typically trade in direct correlation with each other for however long the deal takes to officially close. If one stock goes up 1% in a day, the other should do the same.
Take CBS and Viacom. The long-time frenemies are set to merge in December, ending what has been one of the longest-running M&A sagas of recent memory. When the two sides finally agreed to combine on August 13, 2019, the stock swap ratio provided to investors was 0.5965.
Pull up a chart of CBS and VIAB since then. They’re identical. Well, almost identical.
This is where the strategy comes in. The market knows that CBS and VIAB are set to merge, and we know when, but that doesn’t mean the two will trade in tandem 100% of the time.
With all the macro and micro forces working on stocks—from trade wars, to earnings, to technicals— it’s possible the correlation may get weaker at times. When this happens traders can take advantage of that temporary inefficiency. If, for example, VIAB is up 2% and CBS is only up 1%, it could make sense to short VIAB and go long CBS.
Remember, we know the two companies are merging. Their values are directly tied to each other. By going long CBS and shorting VIAB in this scenario, you’re banking that the two stocks will move back in-line.
Another example is Bristol-Myers and Celgene. When Bristol-Myers agreed to acquire Celgene on Jan. 3 in a cash and stock deal, Celgene shareholders were set to receive $50 per share in cash plus one share of BMY for every share of CELG they owned. Because the deal involved an exchange of stocks, traders willing to keep an eye on the day-to-day moves between the two were able to profit from inefficiencies from that day until the day the deal closed on Nov. 20.
Going back to deal at the top, the ratio of TD Ameritrade shares to Charles Schwab shares is 1.0837—so for every share of TD an investor owns, they will receive 1.0837 shares of Schwab. With the deal expected to close sometime in the second half of 2020, that gives traders ample time trade the two stocks together.
The author is long Bristol-Myers in his 401(k).
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