Posted on: Sunday, February 22, 2004

Mergers not always a sure bet

By John Waggoner
USA Today

Spring is just around the corner, and it's not just the wildlife that has the urge to merge. Being on the right side of a merger deal can mean a quick profit.

But predicting which company will be bought is harder than getting a rabbit to take a chastity pledge. If you want to capture the profits of merger mania, consider the matchmakers: investment bankers. And if you don't want to buy an individual stock, make a date with a financial services fund.

Several big mergers and merger proposals have been in the headlines recently. Cable giant Comcast wants to marry Disney. Cingular Wireless bid $41 billion for AT&T Wireless. Investment bank J.P. Morgan will merge with Bank One.

The irony is that many mergers turn out to be dreadful business decisions.

Ask an AOL shareholder how the merger with Time Warner worked out.

The Boston Consulting group conducted a study in 2002 of larger U.S. mergers from 1995 to 2001. The analysis found that 61 percent of the mergers didn't add value for shareholders of the acquiring company.

But strong economic growth tends to get the merger juices flowing. In a recession, companies look for earnings improvements through cost-cutting.

In a recovery, "companies become more outwardly focused," says Chris Perry, portfolio manager of Turner Financial Services Fund.

"CEOs become more comfortable with combining companies." And interest rates are still low if they need to borrow to buy.

Investors love mergers because the stock of the company being bought usually rises when the deal is announced — or beforehand, if speculation is rife. Investors figure that the purchaser will pay a high price for the company. The stock of the company that's buying usually falls, for the same reason.

Companies may be bought for a number of reasons. They may have production capacity or customers that another company covets.

They may have several divisions that, if the company was hacked apart and the pieces sold, would return more than the purchase price.

Or the acquirer may argue that the two companies are stronger together than they are separately.

Spotting a takeover candidate isn't easy. For many investors, buyouts are a happy accident — a side benefit to buying cheap, down-and-out companies. "I don't chase takeovers," says David Ellison, manager of FBR Financial Services Fund. When a takeover happens, "it's like a blind squirrel finding a nut."

But if you're looking for take-overs, the financial services industry offers a double-barreled play:

• Regional banks are a fertile field for takeovers, says Turner's Perry. Many have reported fat earnings from mortgage refinancing fees. As the refinancing boom cools, many will see earnings growth dwindle. "They will have to acquire to grow in 2004," Perry says.

• Investment banks, which earn fees for arranging mergers, should also benefit. At Lehman Bros.,

for example, earnings jumped to $1.71 per share the fourth quarter of 2003 from 69 cents the fourth quarter of 2002. Investment banking revenue rose 19 percent. Merrill Lynch's Global Markets & Investment Banking division saw pre-tax earnings rise 16 percent last year, to $3.9 billion.

"The prospects for (the investment banks) are pretty bright for 2004," says Mike Holton, portfolio manager for T. Rowe Price Financial Services Fund. Initial public offerings of stock — a profit center for investment bankers in bull markets — are heating up.

During the bear market, many companies reaped profits underwriting bonds and continue to do so. Holton favors (and owns in the fund) Merrill Lynch, Goldman Sachs and Lehman Bros.

Nothing's a sure bet, of course. Derek Rollingson, manager of Icon Financial Fund, thinks the investment banks are fairly valued now. He thinks there's more money to be made in property-casualty insurers and consumer lenders and has no investment banking firms in his fund.

A sharp rise in interest rates could hurt all financial services stocks, although FBR's Ellison argues that modest rate increases will simply enable banks to increase rates — and profits — on loans.

But if you want to cash in on merger mania, a financial services fund may be the best way to get your money to multiply.