Session 26 (of 42): Information Trading - Other Announcements

0:00 Hi, welcome back. In this session, which is going to be my final session on trading and information, I want to go past earnings reports. It is true that earnings reports are the most common way in which companies interact with public markets. But there are other things that can happen to companies. There can be acquisitions that they announce. There can be management changes. There can be stock splits. So while we can't cover all of these announcements, I want to focus on a subset of them and talk about how markets behave around these announcements and whether there's a way in which you and I as investors can take advantage of the market response. So let's start with acquisitions. For many companies, acquisitions are the biggest events that they announce because they have they can have huge consequence for the company. a an acquisition could double the size of a company and often you're paying far more than you've spent on traditional capital expenditures for the last decade. So let's start with a graph that I think captures the essence of who wins and who loses in acquisitions. Remember when you have an acquisition or a merger there are two players. There's the acquiring firm and there's the target firm. And in this graph, we look on average across all acquirers and across all targets, what happens to the stock price of these firms around the date of the acquisition. So day zero is the day that the world knows there's going to be a merger or an acquisition.

1:26 Let's start with the obvious conclusion. If there's a winner in this game, it's definitely not the acquiring firm, it's a target firm. the target firm stock price jumps 15 20% around the acquisition. We'll talk about what that jump looks like across firms and why it might be great at some targets and on others but clearly target firms. Staying with target firms though notice that even before the acquisition is announced the price starts to drift. That sounds familiar right? You saw that with earnings reports the drift in the price before the positive earnings report or the negative earnings report. Clearly somebody is using that information about an acquisition to trade ahead of the announcement. So acquiring firms, their target firms are the clear winners. What about acquiring firms?

2:16 Looking across all acquiring firms much more difficult to find an effect and there's an effect at least over time. It's close to zero in the announcement date. But if you track in the days after it's negative. So there are collective winners and losers here. The winners are the target firms. The losers the acquiring firms. Let's focus on the acquiring firms and see what we can learn about target and acquiring firms from looking across across different kinds of acquisitions. This is from a study that looked at hostile versus friendly mergers. Hostile merger, the target firm does not want to be taken over. The acquiring firm thrusts itself on the target firm. In a friendly merger, both sides want it to happen. It also looks at tender offers versus mergers, cash versus stock, and hostile versus friendly. Let's start with the easiest differentiation here. Target firms in hostile acquisitions do much better than target firms in friendly mergers. Target firms where the payment is in cash do much better than target firms where the payment is in stock. and target firms where the acquisition happens through a tender offer do better than target firms where that's not the case. So the next merger announcement you see you might want to look at hey what kind of merger is it a tender offer traditional merger hostile or friendly cash versus stock because the price effect on target firms varies depending on the merger.

3:44 Now looking at the bidding firm itself the evidence has been mixed. The early studies seem to suggest that even bidding firm shareholders get some benefits. You can talk about synergy and other benefits you get from mergers. But over time those excess returns have drifted down. In fact, if you look at the this century alone, the excess returns to bidding firms has gone to pretty much zero. On average across all bidding firms, there seems to be no excess returns. If you're a shareholder in a bidding firm does an acquisition, you make close to nothing from that acquisition. And that's if you're lucky because in about half of all bidding firms, the stock price goes down. There are negative excess returns around the announcement. You know what the market's telling you, right? The market's telling you you're doing an acquisition if you're the bidding firm and you're paying too much. That in effect, the target firm is getting 100% of the benefits, if any, from the merger plus more. So from the bidding firm perspective, there doesn't seem to be much you can do as an investor to make money. Perhaps in the in some cases, you might even make money by selling short on bidding firms if they overpay. If it's a kind of acquisition where the overpayment is large.

4:57 If you look at why markets are so down on bidding firms, it's perhaps because if you track mergers after the fact, the years after, and you look at how that merger did in terms of delivering the benefits were promised, most mergers don't pass basic financial tests. What's the most basic one? When you take a project as a company, one of the first questions you ask is, do I earn more than my cost of capital? Do I have a positive net present value? And it looks like a lot of mergers don't pass that test. You pay 5 billion for a target firm. You need to generate more than 5 billion in value to cover that price.

5:34 Most mergers don't seem to do that. And second, most mergers are sold in the notion that if you do this, you're going to do better than your peer group. Have higher margins, higher profitability, higher growth. And many mergers fail the test. So a McKenzie study looking at acquisition programs concluded that most mergers don't pass those financial tests. In most mergers, if you track the excess returns in the long term, not just in the days after the merger. In many mergers, 60% of transactions earned returns less than the cost of capital.

6:07 23% earn negative excess return. Only 23% earned excess returns. 77% are negative excess returns. And that magical word synergy that you see thrown around a lot in mergers, a KPMG study looked at synergy specifically. And in the most expensive deals, it concluded that only 17% created synergy. There was value added because remember the essence of synergy is two companies come together and the combined company is worth more than the two individual companies. It's true in only about one sixth of all mergers and 83% of the time the merger was either value neutral. It was a zero sum game or 53% actually destroyed value. The two companies coming together were actually worth less than the two companies standing alone. And here's the ultimate evidence that most mergers don't work.

7:01 If you track merges after the years after a surprisingly large number get get reversed within 6 months within a year within two years and if you track it over longer periods that number rises to close to half of all mergers are reversed within five or 10 years of the merger. The admission from the acquiring firm that the promises were not delivered. So here's the bottom line. When mergers get announced, there is an effect. The target company stock price tends to go up. The bidding company stock price doesn't do much. In fact, it often drops reflecting the market's pres, you know, assumption that this merger is not going to create value for the shareholders of the acquiring firm.

7:44 And if you track the mergers the years after, you can see why. In many mergers, synergy that's promised is not delivered. the performance, the profitability of the combined firm doesn't measure up to what people sold you at the time of the merger. So let's think as investors, is there something we can do to make money around this acquisition process? The most lucrative, of course, is invest in a target firm before the acquisition announcement. That'll require either inside information, which is illegal, or finding a way to predict which companies going to be targeting acquisitions. And I'll give you a couple of ways you might be able to do it. That's the most lucrative because then you get on the ground floor for target firms, the acquisition gets announced, you get that 30, 40, 50% jump in price. You can invest neither the target or the acquiring firm after the acquisition is announced because there is this period where the deal is still being worked out. There's a chance it might fall through, but the deal is being worked out, but there's a price drift and you're taking advantage of that price drift. It's called merger arbitrage.

8:50 It's really not arbitrage but speculation around the merger. And finally, you can wait till the merger is done and invest in companies which you think have done good mergers. Remember what the mergers are going to create value with synergy. And a good merger requires that that value create is greater than the premium paid for the acquisition and sell short in the companies which overpay on acquisitions. It's a pure post announcement strategy. So let's look at how you might be able to forecast which company's going to be targeted in mergers. Research has looked at target firms especially in hostile takeovers where remember the bit the price jump is greatest. And here's what you see as a typical target firm. It has underperformed other stocks in the sector. It's less profitable than other firms in the in that grouping. It has a much lower insider stockholding and it trades at a lower price to book ratio.

9:42 So these are not a typical target firm is a badly performing company. The market is turned down in the company. So you know what you could do? You could take an industry group and look for the worst performers. The worst performers that are trading at the lowest prices. You can invest in those companies and hope and pray that they get targeted. Are you going to be right 100% of the time? Of course not. But even if you're right 20% of the time, one in five of your companies gets targeted, the money you're going to make on those acquisitions is going to cover the cost of the other four.

10:16 So you're basically estimating which firms are potentially good target firms. A more sophisticated technique is called a probit which is a statistical technique for estimating the probability of getting taken over using observable data such as you know under profitability inside a holding. So you're basically taking what you learned from research putting it through a statistical technique and then investing in companies the pro but the probit suggests that the probability of being taken over is higher. So acquisitions are a noisy process. We've learned a lot from looking at acquisitions in the past and perhaps as investors we can take advantage of what we've learned to make money off acquisitions.

10:58 Now in terms of post announcement trading it's tougher because it's a longerterm strategy and you're looking for acquisitions where the acquiring firm in fact has got a good deal right because that's the only firm you can invest in postacquisition. So remember the likelihood of success for mergers is greater in hostile acquisitions of course friendly. It's greater when you do mergers of like businesses because where you have cost savings and you go for growth and potential synergies.

11:28 And it's greater where you have firms where companies actually plan for synergy before they're done. And finally and this might be a potential value creating strategy if you're an investor. The chance of success rem is greater when you acquire small private companies and you pay a premium over what that owner of the private company thinks a business is worth but less than you would have in a public market. Now the rollup strategy is one example of this where companies are created by rolling up small private businesses and there's been a history of success there and maybe as an investor you can latch on.

12:04 That's the acquisition process and potential ways of making money on it. Let's look at a few other information announcements in passing and see what we can learn from from market reaction. Stock splits. What's a stock split? It's the most cosmetic of all corporate actions. Right? You take a share, you split into two shares. Nothing changes about the operations. By itself, a stock split should have no effect on value, but does seem to affect prices. A stock splits on average tend to see stock prices go up. And you can tell a signaling story. Only good companies split their stocks. The fact that you're splitting your stock must suggest you think good things are going to happen.

12:43 So on average, stock splits go with higher prices. But that price effect happens before the stock split. Most companies split their stock after they've had an extended price run up. So if you go out and buy a stock after a stock split, there seem to be nothing much left on the table for you. In fact, if nothing else, you could argue that stock splits increase your transactions cost because remember we said bid ass spreads as a percent of price are higher at lower price stocks. So stock splits are a cosmetic event not surprisingly it's very difficult to think of ways of making money of stock splits or stock dividends. What about dividend changes here? It's a tougher call because companies do, you know, we talked about this earlier in the context of sticky dividends are reluctant to change dividends and when they do, they're far more likely to increase dividends and decrease them. And when a company changes dividends, there's information that's conveyed to the market. When you have a dividend decrease, the stock price tends to drop. And this is around the announcement because remember the board gets together, announces dividends will be higher, lower, stay the same.

13:58 So, if there's a dividend cut, stock prices tend to drop by about 4.6% on average. When dividends are increased, stock prices tend to go up, but only about 1%. That sounds asymmetric, right? That a dividend increase has a much smaller positive impact than a dividend decrease has in terms of lowering prices. And the explanation for that is in the in in what you found when you looked at dividend changes over time that companies are far more likely to increase dividends and decrease dividends. So when you see a dividend cut, it's much bigger bad news than when you see a dividend increase. But on average at least, there's a price.

14:39 But if you track these dividend changes over time, it turns out that dividend changes have become less informative over time. What am I talking about? This actually looks at that effect of a dividend increase or a decrease over time, but then it breaks it down by sub periods. In 1962 and 74, dividend changes were pretty informative. That's what you saw in that study that I just showed you. If you update that study to 75 through 87, dividend increases have become a slightly less positive and dividend decreases much less negative.

15:10 And by the time you get to 1988 through 2000 and I'll wage if you track this up through 2024 that the effects have decreased. Dividend changes have become much less informative. You're saying why? Because the information we have on companies has become richer. We have so much more data on companies. We don't have to wait for a dividend cut to know that a company's in trouble. And the market seems to be reflecting it. So dividend changes convey information, yes, but they convey less information than they used to.

15:42 So let's look at information trading in general. Look at what will determine whether you can succeed as a trading and information. First, you got to be specific about the information you're going to trade on because that's the point at which you got to trade and you got to invest in an information system that delivers that information to you about the event instantaneously. So you're going to trade an earnings report. You need to know when that earnings report comes out and what it contains almost immediately. Even 15 or 20 minutes lag. If you have a lag of 15 or it might be too much by then the price might already fully reflect it.

16:17 You need to execute quickly. The problem with so much information coming out after the close of trading is by the time you get a chance to trade the next morning, the price impact might be fully in there. You got to keep a lid on transactions cost because you're going to be trading a lot more than somebody who buys stock and holds it for the next 5 years. But since you need to trade quickly and keep cost low, it's going to be it's going to be it's going to be a challenge to keep that balance. And if you do trade on information, let's say you buy on an earnings report which is much better than expected, hoping to gain from the drift, you need to know when to get out because that drift doesn't last forever. It might be for a day. It might be for a week. You need to know when to sell. Trading information is tricky and it's getting trickier in a world where it's so much easier to trade and information is so much more accessible. I'll wage that where people who made money on earnings reports two decades ago, three decades ago are not able to do it anymore because the process is speeded up and compressed.

17:22 But if you decide to embark down this route, I wish you the best. Thank you very much for listening. And I hope you found the session useful.