Do Not Buy The Rumor, Buy The Pullback

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 |  Includes: JOSB, LO, RAI, T, TLRD
by: Joel Elconin

Summary

Price action in DirecTV since rumors of merger with AT&T surfaced.

Price action in Lorillard since rumors of mergers with Reynolds American Inc. surfaced.

Strategy for playing potential takeover candidates.

With the merger and acquisition market heating up as of late, it is tempting to try and capitalize on the activity. However, buying on the rumor and selling on the fact, may not always be the best strategy.

More times than not, the initial surge that takes place may have you enter the issue at an inflated price. And if the deal immediately falls through or is rejected, it may result in a substantial loss. As with any investment strategy, timing is the key to profits.

Any investor that tried to play the Joseph A. Banks-Men's Wearhouse saga, may have been chopped to pieces and ended up losing money from the eventual merger. The rip in Men's Wearhouse (MW) took the issue from $45.00 to $58.80 when it was rumored that they were an acquisition target of Jos. A Bank Clothiers (JOSB). But when all was said and done, MW ended up buying JOSB instead, and MW is now a $50.00 stock.

Those who opted for the JOSB positions fared much better as the issue initially rallied from $55.00 to $60.00 and ended up going off the board at $64.50.

A good example of the taking the wait and see approach is exhibited in the recent price activity of DirecTV Group (DTV). On May 1st, Dow Jones reported that AT&T (T) had approached DTV regarding a potential acquisition.

The news that broke during premarket trading instigated a spike from its closing price on April 30th ($77.60) to $84.04. However, as the deal failed to materialize the next day and over the next few days, the issue drifted lower to almost the exact closing price it was at prior to the announcement. Four days after the initial rumor surfaced, DTV briefly traded to $77.50 ($0.10 below its closing price on April 30th) but rallied to end the session at $81.74

Obviously, opportunistic investors flocked into the issue based on the premise that there was still potential for the deal to materialize. As if the AT&T rumor was a substitute for downside protection (analogous to the "Bernanke put" with his willingness to support the market with Quantitative Easing for as long as needed).

Lo and behold these investors were rewarded late in Wednesday's session, when it was reported by Dow Jones that DTV was working with advisers, including Goldman Sachs, on a potential deal with AT&T. DTV, which had already rebounded to the $84.00 level, spiked to $88.57 and ended the session at $88.25. In Thursday's session, DTV has retreated to $85.50. Perhaps all those investors who had loaded up on the issue during its initial pullback are cashing out and putting their profits to work elsewhere.

Another example of this type of price action has taken place in the rumored acquisition of Lorillard (LO) by Reynolds American Inc. (RAI). Although it is not quite the textbook example of the T/DTV deal, it certainly has similarities.

On March 3rd, the Financial Times reported RAI was eyeing LO as a potential acquisition. Although the company spokesperson declined to comment on the report, the share price of both issues soared. RAI rallied from $50.83 to $53.39 and tacked on another three plus points to $56.31 the following session. Investors were taking the stance that the takeover would add to the bottom line for the acquirer.

LO reacted positively to the news and rallied from $49.06 to $55.26 during this same time period. However, when the deal failed to materialize, LO drifted lower over the next seven trading sessions to close at $51.01 on March 13th. Although it was still $2.00 from its closing price before the rumor surfaced, it still attracted investors that believed the company was still in play.

Once again, the RAI bid acting as a substitute for a put on the issue. From its $51.01 close, the issue began to rally in attempt to recoup its losses from its initial surge to the $55.00 area. Investors that got the early word on the deal took the issue from $55.25 to $57.51 on April 29th.

And when CNBC's David Faber reported on April 30th there had been "a lot going on" between LO and RAI, the issue tacked on another two points to $59.42 in the following session.

Since that time LO has retreated slightly from that level as the savvy investors that bought the pullback are taking profits ahead of the actual announcement of the actual deal, fearful that if the deal does not take place LO may return to the level it was trading at before the rumors surfaced.

Playing the rumor mill can produce substantial profits as well as substantial losses. Since each potential deal has its own unique circumstances, there is no definitive way to capitalize on each and every deal.

However, if you can resist the urge to buy the initial spike, keep a close eye on an issue's closing price prior to the rumors surfacing. If the trading action that takes place is anything similar to DTV and LO, you just may be able to participate in the deal with a much better risk/reward ratio.

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. I have no business relationship with any company whose stock is mentioned in this article.