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How To Accurately Predict The Future Value Of A Stock

What if I told you that there exists an investment strategy where you can buy a stock already knowing what the price is going to be 4-6 months down the road?

Sound too good to be true? It isn't. In fact, this strategy is known and employed by thousands and thousands of sophisticated investors.

In fact, this strategy can be used on a couple of current Magic Formula® Investing (MFI) stocks today for annualized gains exceeding 14%.

What is this strategy? Let's take a look.

When A Company Loves... Another Company

Mergers and acquisitions happen all the time in the market. Usually, a larger company will offer a premium to shareholders of a smaller company that has technology, customers, products, or talent that the larger company desires.

Immediately, the stock price of that smaller company (the "acquired") shoots up to somewhere in the neighborhood of the buyout price.

However, here is where it gets interesting. In most cases, the acquired's stock price doesn't go all the way to the buyout price. There are still some risks to consider (we'll discuss those later), and a premium will remain to account for those risks.

This is where the merger arbitrage strategy can be deployed. In most cases, M&A deals take anywhere from 4-8 months to close. We know that, in most cases, deals tend to close at the announced price. Given this, we know the two most important things in investing: what a stock's price will be on a given future date. It is easy to calculate an annualized gain given the current premium to the buyout price and the distance to the buyout close date:

Total Gain Potential = (Close Price - Current Price) / Current Price
Annualized Gain Potential = (Total Gain Potential / Days To Deal Close) * 365

Really, that's about as sure a thing as you can get in stock investing.

There are a few things to consider first, however...

Merger Arbitrage Risks

The biggest risk in merger arbitrage is that of a deal falling through. When that happens, the stock price of the acquired usually tanks, as arbitrageurs exit the stock en masse, usually with sizable losses. While there are many things that can scuttle a deal, there are 3 main reasons to consider before entering an arbitrage play.

1) Regulatory Risk. Uncle Sam (and his international brethren) often has something to say about the larger mergers, owing to his role as a trust and monopoly buster. If a deal will create a dominant market force, the FTC or Justice Department (DoJ) will likely shoot it down. We saw this prominently a few years ago when the AT&T / T-Mobile merger was scuttled by the DoJ.

2) "Break-off" Risk. This is when the one or both sides experience problems in consummating the deal and it ends up being broken off. There are a wide range of reasons this may happen: difficulties securing financing, due diligence uncovering new concerns, an adverse event in ongoing business, major shareholders voting down the deal, etc. In general, the more complicated the deal, the higher likelihood of break-off issues being encountered. Many deals have break-off fees attached to assuage investor fears about situations like this.

3) Floating Value Risk. Floating value is not a big concern in an all-cash deal - you know exactly what you will get, in cash, for your shares. However, many deals are structured as cash-and-equity, which means you get some cash per share and also a partial number of shares in the new company as compensation. The equity component makes the certainty of the deal less so. If the stock of the acquirer falls substantially (due to any number of reasons, including the deal), the entry point on your arbitrage play may no longer look attractive when the deal closes.

In general, the "safest" merger arbitrage stocks are those of smaller (under $5 billion or so) companies in competitive industries, structured as all-cash deals. The riskier ones are the mega-mergers between huge, global enterprises that often face regulatory scrutiny, or ones with a complicated set of financing contingencies. Of course, as usual, often the more risk involved, the greater the potential for gain.

Two Current Magic Formula Arbitrage Situations

We'll wrap this up with a look at two current MFI merger arbitrage plays: IGT (IGT) and Lorillard (LO).

International Gaming Technology (IGT):

  • Being acquired by: GTECH S.P.A., an Italian casino gaming equipment maker.
  • Announced on: 7/16/2014
  • Expected to close by: 6/30/2015
  • Deal value per share (approximate): $18.25
  • Structured as: Cash-and-stock, with $13.69/share in cash and the rest a variable amount of GTECH stock based on its price at close date.
  • Current IGT price: $17.04
  • Potential gain: 7.1% (16.3% annualized)

Lorillard (LO):

  • Being acquired by: Reynolds American (RAI), the #2 U.S. tobacco company.
  • Announced on: 7/15/2014
  • Expected to close by: 6/30/2015
  • Deal value per share (approximate): $70.51
  • Structured as: Cash-and-stock, with LO shareholders receiving $50.50 in cash and 0.2909 shares of RAI for each share of LO.
  • Current LO price: $65.71
  • Potential gain: 7.3% (16.8% annualized)

Two very similar deals with similar upside potential! Of the two, I feel the IGT deal is probably the "safer" of the two. The RAI/LO deal faces some serious FTC scrutiny, as afterwards Reynolds and Altria (MO) will control 84% of the domestic tobacco market - effectively a duopoly. Some have put the likelihood of an antitrust blockage as high as 50%. Additionally, the RAI/LO deal is a fixed amount of shares, which makes the ultimate closing price a moving target based on RAI's stock.

The upside for both deals is fairly good at current trading prices, although the prospect of holding RAI or GTECH shares is not enticing (if it were me, I'd sell both immediately after closing).

Merger arbitrage is a nice investing tool to carry on one's belt, as attractive opportunities do come along fairly often and the risk/reward involved with them is normally in the investor's favor.

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