Charting Asia

Published: Wednesday, 7 Oct 2009 | 4:02 AM ET

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US food giant Kraft

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[KFT  Loading...      ()   ] has been in the spotlight in recent weeks following its $16 billion bid for British chocolate firm Cadbury. For investors holding the company's stock, should they buy, hold, or sell?

Takeovers are more about trading strategies rather than chart analysis. The takeover dance usually has 2 or 3 steps and sometimes more.

The dance starts with the offer from the predator to the target prey. This offer is routinely rejected as far below fair value which is decided by an independent valuation report commissioned by the prey.

The second dance step is when the predator increases the offer made to the prey. This offer may include an additional sweetener such as cash or options as well as shares. The prey plays hard to get, and often the predator will need to increase the offer a third time.

This dance has a rally and plateau effect on the price chart of the prey. The target company rallies as traders anticipate a higher offer from the predator. Price consolidates and moves sideways until the new offer is received.

The predator bleeds capital, or debt, in the takeover. Unless it has a particularly strong balance sheet the market treats the predator with caution. The reaction away from the consolidation level between $28.00 and $29.00 confirms this cautious reaction. There is often downward pressure on prices for the predator so it's important to look for successful support areas. With Kraft these are near $23.50.

However, the real dance action is in the trading, not the chart analysis. Takeovers provide two trading opportunities. The first is a classic capital appreciation strategy applied to trading the target prey. The second is a conversion strategy where traders buy the target  shares and hold them until the takeover is competed and they are converted into predator shares. 

The classic strategy is to buy the prey company because the predator invariably lifts the takeover offer price. If there is more than one predator chasing the target, then counter bids quickly add up to capital gains. This is trading for capital gain.

The conversion strategy relies on buying the target prey shares and holding them until they are absorbed into the predator shares.

This is a type of arbitrage style opportunity because we know the future price of the instrument, and are able to compare it with the current price combination. The math is not that difficult, but using a spreadsheet makes the calculations much simpler.

We start calculations by characterizing the two players as the target and the predator.  The two most important variables are the price at which the trader purchases the target shares, and the eventual value of the predator shares once the takeover is completed.

We start with the current cost of the target shares. The offer has been announced, and we need to decide if we buy target shares today just how profitable this may be in the future given changes in the price of predator shares. Once we know these figures we can make a better estimate about the risk of the trade.

Next we establish the conditions of the takeover. In this example the predator is offering 20 predator shares for every 100 target shares.  

The next most important variable is the current price of the predator shares. This price will change over the course of the takeover. The take over conditions remain in place for an extended period while the price of the predator shares varies according to market sentiment. Traders who decide to wait and convert their target shares into predator shares need to understand the impact of these price changes on the profitability of their trade.

The assumption is that the conditions of takeover remain the same. Once the predator price drops below $12.00 in this example this strategy becomes unprofitable. It is not until the predator price, when the shares are converted, reaches more than $13.80 with a 10% return, as shown by the red lines, that this strategy becomes relatively profitable.

Predator and prey calculations allow traders to make a better judgement about the strategy they prefer to use when  a takeover offer is made. It tells them which is sweeter – Kraft or chocolate.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at . We welcome all questions, comments and requests.

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