Consider These Stocks for Exposure to the Surge in M&A Activity

by: Mike Maher

Usually the announcement of an acquisition has a very predictable impact on the shares of the companies involved. The stock of the company being acquired jumps higher, as the takeout offer is usually at a premium to the price the shares before the announcement. The stock of the company making the acquisition falls, as investors worry about the cost of the merger and complications of the integration. However, the last few weeks have seen this status quo shattered, as acquisition announcements have lifted shares in the company pursuing the acquisition. A few examples:

April 1, 2011: Nasdaq (NASDAQ:NDAQ) rises on its joint bid for the NYSE (NYSE:NYX)

April 5, 2011: Texas Instruments (NYSE:TXN) rises on its bid for National Semi (NSM)

April 11, 2011: Level 3 Communications (NASDAQ:LVLT) leaps on its bid for Global Crossing (NASDAQ:GLBC)

April 13, 2011: Silgan Holdings (NASDAQ:SLGN) up on its bid for Graham Packaging Co (NYSE:GRM)

April 13, 2011: Eagle Rock Partners (NASDAQ:EROC) soars on its bid for Crow Creek Energy.

While each individual deal has its own unique characteristics, the trend of the acquirer moving higher may have some common themes. As companies slashed costs and reined in expansion plans during the recession, they were able to expand margins and grow profits as the economy begins to rebound. However, revenue growth has been lackluster, and investors have begun to question if new high levels of profitability are sustainable in the current environment. Acquisitions are a way to expand the business and continue the success in cutting costs, as overlapping administrative costs can be stripped from the combined company. Costs can also be lowered as firms get bigger and achieve greater economies of scale, further supporting margins.

A second explanation could be that investors are cheering smart allocations of capital. The low interest rate environment makes keeping cash on the balance sheet less attractive for corporate boards, and has made financing for deals cheaper, helping to spur activity. Without revenue growth and with a lot of spare capacity in the economy, spending capital to construct new factories or facilities does not seem prudent. Buying out competition allows companies to remove some pricing pressure while positioning for growth later on in the economic cycle.

Whatever the reason, the markets are cheering deal making. Expect investment bankers to press this point as they attempt to sell new deals to other boards of directors. Deal activity is back in full force in the global markets, and expect the trend to continue throughout the year and into 2012. This strength was evident in JP Morgan's investment banking results reported this week, and should benefit the pure play investment banks. Investors looking to gain exposure to the space can look at smaller firms to attempt to focus strictly on investment banking, striping out the headwinds larger names in the space face. Such names include Evercore Partners (NYSE:EVR), Greenhill (NYSE:GHL), and Lazard (NYSE:LAZ).

For FY 2010, Evercore generated 75% of its net revenue from Investment Banking, down from 86.5% in 2009. However, revenue for the division was up 3% YoY. Shares currently yield 2.2%.

Greenhill's FY 2010 results show that Financial Advisory fees were responsible for 91% of the firm's revenue in that year, up from 72% in 2009. Revenue in that segment increased 17% YoY. Greenhill completed its separation from the firm's Merchant Banking business at the end of 2010, although the firm kept that business' portfolio. Shares have a current yield of 3%.

For Lazard's FY 2010, Financial Advisory revenue was responsible for 57% of the firm's revenues, down from 62% in 2009. Financial Advisory Revenue was up 13% YoY to $1.1206 billion in 2010. Shares yield 1.2%.

All three of these investment banks derive the majority of their revenue from investment banking, without the exposure to consumer credit or the U.S. housing industry that their larger competitors are burdened by. In addition, all three provide a yield over 1%, higher than the current payouts of Morgan Stanley, Goldman Sachs, Bank of America, or Citigroup. Investors looking for exposure to the surge in mergers and acquisitions, without being exposed to other issues facing large U.S. banks, should consider these names.

Disclosure: I am long MS, BAC, LVLT.