By WallStreetDaily.com

It only took a day for the takeover explosion to spill into May, as two more deals were made public yesterday.

Jive Software Inc. announced that it was being acquired by ESW Capital in a $462 million deal.

The offer represents a 20% premium to where Jive Software was trading on Friday.

Duke Realty Corp. (DRE) also formally agreed to be acquired as part of a $2.75 billion cash deal with Healthcare Trust of America Inc.

Despite the fact that 68 deals have already been consummated in 2017, with 91 more pending…

Most of my readers remain oblivious to the explosive nature of takeover investing.

If you’re among the oblivious, please take notice — Trump is resurrecting previously dead money.

The president’s first 100 days in office have witnessed $729.14 billion in takeover deals hit the books.

Without any barriers to entry, Main Street investors have every right to claim their slice of the pie.

I asked my senior analyst, Martin Hutchinson, to conduct a precursory review of takeovers. That is, because I’m projecting over $3 trillion in deal flow this year.

Hutch’s full analysis is below.

Ahead of the tape,

Louis Basenese
Chief Investment Strategist, Wall Street Daily

Question: Martin, you’ve agreed to help us compile the ultimate library of investment catalysts. Now, these are the most important investment catalysts out there, and they’re baseline concepts that every investor should know about.

Today we will be discussing takeovers. So let’s jump in right now, Martin. I’ll start at the very beginning. What’s a takeover?

Martin Hutchinson: Well, a takeover is when either a company or a financial institution makes a bid for a company (in which you owns shares).

Usually, it’s great news for you as a shareholder. The bids can be either partial or complete. In other words, they can take over part or all of your company. They may use cash, they may use shares or they may use some bizarre mixture of the two.

Question: Correct me if I’m wrong, but a bigger company would look to take over a smaller company to grow — just to bolt on a whole line of business. It would allow the larger company to grow in a nonorganic fashion, so to speak, by just basically taking over another company’s operation. Is that why takeovers are mostly done?

Martin Hutchinson: There are a lot of reasons why takeovers are done. But that’s the good news, in the sense that the management actually has a coherent strategy. Bolting on an additional new business by taking over another company is by and large the most effective way of adding a new business to your existing lines — if you’re not already in that business. Because growing new businesses from ground zero can take an awfully long time and cost a lot of money.

Question: But you’re suggesting that there are other reasons why a company would do a takeover?

Martin Hutchinson: There are indeed other reasons. I mean, one reason, for example, is you buy a competitor because it increases your market share. That’s why all the takeovers were done in the banking sector back in the ’90s, for example. They were expanding their geographical reach and expanding their market share of U.S. banking.

As a result, we’ve got several big banks that own about 10% of the total now. We had none at all in 1990. So those market share takeovers are another set that are interesting.

Those are both positive takeovers. There’s also a negative takeover in the sense that you’ve got a declining business. With this, you’d combine two operations in the same business and then you’d cut out the costs and fire a lot of people.

Retailing, for example, is having to do that quite a lot. I think you’re going to see a lot of takeovers in the retailing space in the next couple of years, just with people combining their operations, selling stores, laying off employees, combining their computer systems, reducing their overhead.

So hopefully at the end of it ending up with a more profitable operation. But quite often, they’re just pouring more money into a declining space.

Then, finally, the other reason for doing takeovers is what one can describe as sheer bloody empire building by management. Because there is, unfortunately, the simple arithmetic by which the larger the company you control, the larger the CEO compensation package can be in terms of cash, bonus, stock options and so on.

So quite often, managements just build an empire for the sake of having built an empire. You can see that, for example, with Valeant, which was the drug company that bought a lot of other drug companies and then pushed up the prices of their drugs. And it did it all with leverage, and eventually the house of cards came tumbling down.

So those last two examples — where it’s cutting costs — are probably not beneficial for the shareholders being taken over. (Although going bust is obviously worse.) Then empire building by management, if you are a shareholder in the inquiring company, you’re going to want to ask some very hard questions of management if it looks like they’re doing that.

Question: Now, Martin, say you own shares of a takeover target — regardless of whether it’s one of the two reasons to take over that are positive or one of the two that are more viewed as negative. If you’re a shareholder of the takeover target, the offer will be at a premium.

So you win either way if you’re the shareholder of that company, correct?

Martin Hutchinson: Correct, provided you sell out.

In other words, the market price adjusts immediately fairly close, usually, to the price of the takeover.

Why? Because there’s an arbitrage game whereby big professional traders can buy the shares and then tender them into the bid, assuming it’s going to work. Or better still, hope a takeover war will break out in which two or more bidders come in and push the price way up.

Those arbitragers will make out like gangbusters in that case, one will certainly make decent money, if they buy the shares immediately and then tender them into the bid.

But for you as a small shareholder, you’re actually better selling into the initial offer, because the share price will get you 80% or 90% of the way to the bid value immediately.

Question: If you don’t mind, Martin, let me walk our listeners through exactly what you’re talking about — in the hypothetical.

Suppose you own ABC Corp. that’s trading for, say, $6 a share… and another company just came in and offered $9 a share to buy the company. That price is signed off by the shareholders. That wouldn’t trade at $9 upon the announcement. It might trade at $8.25 or so as the details are worked out and it passes all the regulatory hurdles.

You’re suggesting just go ahead and sell it at $8.25 right then and there and take your profit?

Martin Hutchinson: Go ahead, sell at $8.25. You’d make $2.25 on $6 investment. Frankly, it’s not worth waiting for the other 75 cents. In general, that’s my advice.

The reasons for that? The arbitrage game is for pros. And the bid can get derailed by antitrust or other regulatory things. If it’s a multinational company, you’ve got the EU, the Japanese and God knows who else involved. If the buyer has offered you shares that are worth $9, you may find that the buyer’s share price goes down.

I got caught that way once where the buyer’s share offer was worth $59, and then I held and transitioned into the bid and ended up with shares worth $42, which is what they were worth the day before the bid.

So in fact, I’d have done much better not buying the thing at all. But certainly, I’d have done better selling on day one and not waiting, because the buyer’s shares went down.

Then finally, if it takes months and months to close, that’s dead money. You’re waiting there for the thing to close. Maybe it’ll be interesting once it’s closed, but it’s not going to do anything exciting while lawyers are busy pushing papers around and, indeed, incurring costs, which are very, very substantial in these.

Eventually, the buyer’s shareholders are going to pay those costs. That’s no good for them, either.

Question: Martin, through my experience in trading, the chart always looks the same when a company has been taken over — or at least while a takeover is still pending.

It usually has the normal volatility you would typically see in a stock, but then all of a sudden you’ll see a day where the stock gaps open much higher. Then it starts to trade in a very tight range, but it’s still trading shares. That’s typically a company that has a takeover bid in play, and we’re just waiting for it to formally close, correct?

Martin Hutchinson: That’s correct. So it’s dead money while it’s trading in that narrow range, which is not a bad thing. But if the buyer has offered you shares, those shares can go down in value. You are still at risk.

The only reason to hold off after the bid’s announced is if you think there’s going to be a higher bid in the takeover battle. Because, obviously, sometimes, once the company’s agreed to a takeover, it’s been put in play. If it’s anything of a unique asset or has a very attractive position within the industry, then there’s quite a good chancethat other companies will come in and bid higher.

Obviously, in your initial example, you own the shares at $6, somebody comes in and bids at $9. If you think that’s all there’s going to be, you’re better off selling at $8.25, not waiting around. But the real gold is if somebody comes in and bids $11 and then a bidding war breaks out between the two and they end up selling for $14. At that point, you’ve made real money.

But those are less common than you might think. Because if you’ve got that situation where the first price they think of is $9 and then it ends up at $14, the guy who pays $14 has almost certainly paid too much and ripped off his own shareholders. He’s going to get some nasty questions in the next Annual General Meeting.

Question: Do you want to cover the tax advantage, Hutch, before I go with the takeaway?

Martin Hutchinson: If you’re a shareholder, there’s a tax advantage in not selling immediately and holding and then tendering, if it’s a share-for-share swap. So if the bidder offers you just shares and therefore becomes a share-for-share swap… 100 of ABC becomes 50 of DEF, and then that’s a nontaxable event. So there are no capital gains taxes to pay.

Whereas, if you sell for the $8.25, or if the bid was for cash at $9, you’ve got to pay capital gains taxes on your capital gain.

Question: Sounds like the key takeaway here is that if you can own companies, if you’re playing the small-cap game, it’s good to own companies that have a competitive business that might get taken over. Not only do you like the company itself, but it might be attractive to a bigger company. Because you win in the takeover game by holding the takeover target and you get that initial pop.

Is that the key takeaway here? To own small-cap companies that are also good takeover targets here, Hutch?

Martin Hutchinson: I think that’s right. You’ve got particular sectors, like resources, for example. Big mining companies are always losing their resources because the mines get depleted. So they’re always looking to buy small companies that haven’t developed the resource but have got a bunch of mineral rights. Then those small companies become great takeover targets.

So overall, mining companies or otherwise, it’s a great thing to own a company that might get taken over, because you may get an additional pop.

Before we wrap, I just want to clarify the note about tax advantages with certain takeovers. A takeover bid that’s cash doesn’t get a tax advantage. You have to pay capital gains tax when you either sell the shares for cash or tentatively tender it into a takeover bid of cash.

But if the takeover bid is for shares, then that’s what’s called a share-for-share swap. In other words, you’ve exchanged 100 shares of ABC for 50 shares of DEF. That’s a nontaxable event. So you can then go through that without paying capital gains tax, which is an additional advantage.

Question: Great insights as always, Hutch. Thanks a lot.

Martin Hutchinson: Great to be with you.

Question: This is Wall Street Daily, signing off.

Smart investing,

Martin Hutchinson
Senior Analyst, Wall Street Daily

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