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Predator or Prey? Chart the Better Deal

Mergers and acquisitions. It's the business of how companies buy, sell and recombine each other. M&A is the reason why many conglomerates are made up of highly diverse business units.

M&As can be friendly like Rio Tinto's acquisition of Alcan, or they can be hostile, as in the case of BHP Billiton's unsolicited offer for Rio. The offer was ultimately withdrawn, but it would seem that there are many parties still interested in a piece of Rio Tinto. All the better for investors looking to make money.

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How do we find the choicest morsels of opportunity? Do the best buys come in the form of the predator, or will the prey provide the best trading opportunity? The solution comes from a combination of chart analysis and trade analysis.

Takeovers provide a range of arbitrage style opportunities as market inefficiency develops as crowds become excited. These opportunities develop when we know the future price of the instrument, and are able to compare it with the current price combination. The maths is not that difficult, but using a spreadsheet makes the calculations much simpler.

There are two basic strategies. The first is a classic capital appreciation strategy. 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 target company because there is often a lift in the takeover offer price before the deal is concluded. If there is more than one predator chasing the target, then the probability of counter bids is increased dramatically. Many traders simply buy the target stock and wait until the final deal is settled. This is trading for capital gain.

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

We start calculations by characterizing the two players as the target and the predator. The predator makes an offer for the target shares, and may include some form of cash sweetener to make the deal more attractive. 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.

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Once the offer has been announced, we need to calculate how profitable it would be if we we bought target shares today, just how profitable this would be 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. In this example we use 1,000 shares. What's important is the percentage return on capital.

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Next we establish the conditions of the takeover. In this example the predator is offering 20 predator shares for every 100 target shares. An important variable is the CURRENT price of the predator shares - $13. This price will change over the course of the takeover.

Usually the takeover 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.

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Cash sweeteners tip the balance and they must be calculated separately. In this example the predator is paying $150 for every ten shares, so the cash sweetener worth $150. These calculations are bought together to assess the risk and reward of the trade. The important figures are the percentage returns. In this case, without the cash incentive, the return from this conversion strategy is a negative 32 percent. With cash, this conversion strategy returns 5.94 percent.

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The major variable underpinning the success or failure of this strategy is the current price of the predator shares on the day of conversion. The broad strategy calls for the trader to hold the target shares, convert them into predator shares, and then sell them to lock in a profit. The diagram shows the impact of changes in the share price on the profitability of this trade. The assumption is that the conditions of takeover remain the same.

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Once the predator price drops below $12.00 this strategy becomes unprofitable. It is not until the predator price reaches more than $13.80 with a 10 percent 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 the whiff of a takeover is in the air. A spreadsheet template is available free from support@guppytraders.com


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