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Announcements of mergers and acquisitions (M&A) usually initiate a very interesting chain of events. In the course of which the target company will usually see its share price shooting up while the acquiring company is likely to see its share price drop.

One very interesting example as of late is the much-discussed potential takeover of Yahoo! (NASDAQ:YHOO) by Microsoft (NASDAQ:MSFT). For those of you who are not familiar with the details, it is not the first time Microsoft is playing this game with Yahoo. 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 price share of Yahoo! rocketing from $13.17 to $15.8, an increase of approximately 20% in a very short time period. You can easily check on this rumor and its whereabouts on Reuters.

Another example of the aforementioned chain of events is the rumored takeover of SABMiller (OTCPK:SBMRF) by Anheuser Busch Inbev (NYSE:BUD). Similarly to Yahoo!, the share price of SABMiller shot up by approximately 10% since the rumor began to spread. You can check on that rumor on Forbes.

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.

But there is another way, a profitable one, to play M&A rumors.

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.

You can check out their article here (.pdf).

In summary, taking into account the statistics I have mentioned, as well as Microsoft's lousy past takeover experience with Yahoo! back in 2008, leads me to recommend to sell Yahoo! short and buy to cover in 60 more days.

A second marriage with the same spouse almost always fails to succeed.

Source: Short Yahoo On Acquisition Rumors