How You Can Make Money On Acquisition Rumors

During the pre-market session on June 6th, shares of SodaStream (NASDAQ:SODA) traded higher by 26%, to a price over $87. The gains were in response to a report that Pepsico (NYSE:PEP) was looking to buy the at-home soda maker. This marked the second day in a row that these rumors were being spread, although Wednesday it was Coca Cola (NYSE:KO) reportedly looking to buy SodaStream. Apparently, the rumor mill has been working exceptionally hard lately.

Not the first time

Roughly two years ago, there was a pending rumor on a potential takeover of Yahoo! (NASDAQ:YHOO) by Microsoft (NASDAQ:MSFT). The very mention of the word 'takeover' in the context of Yahoo! and Microsoft was enough to trigger a chain of rumors, which resulted in the share price of Yahoo! rocketing from $13.17 to $15.8, an increase of approximately 20% in a very short time period.

From rumors to action

So, if an investor wishes to make money from an M&A activity, she must correctly time the M&A announcements and either purchase shares of the target company or sale short the shares of the acquiring company, right?

Well, not exactly. It turns out that this timing-task is on the verge of impossible. In addition, any attempt to purchase shares of the target company AFTER the M&A rumors have become common knowledge has been proven to be a non- profitable strategy. As an illustration, anyone who bought SodaStream at the peak price of $87 is now sitting on losses of 16% in less than a week. These type of fast and furious losses are difficult to recuperate. But there is another way, a profitable one, to play M&A rumors.

How to look at rumors - the right way

According to a research by Yuan Gao and Derek Oler on M&A rumors and pre-announcement trading, in most cases, rumors fail to materialize into public announcements. It turns out that short selling rumored acquisition targets is, in fact, a profitable strategy.

The researchers further elaborate that on average, stock prices of rumored firms drift down to their pre-rumor level over a 70- day period AFTER the initial price jump and that only 12% of rumored takeovers materialize into actual announcements within 70 days. The average return to a shorting rumor strategy over this period is 4.2% (above index) and when one restricts this strategy to only include "hot" M&A years and exclude extremely large mega cap firms, profits increase to 12.7% (again, above index).

In other words, in 88% of the cases, rumors fail to materialize (due to a thousand different reasons) and the investors who were previously rushing to take a piece of the action are now rushing for the exit.

The explanation that the two researchers attribute to this phenomena is very clear - the market always overreacts to takeover rumors. Combining this psycho-financial fact together with the finding that 88% of the rumored takeovers never actually materialize, leads to a profitable robust short - selling strategy.

Some final thoughts

There's no need to rush and try and buy shares of a rumored target company. In most cases, you'll make much more money by shorting the target company right after the rumor has spread. It turns out that in most cases, well, rumors are nothing more than just rumors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.