A recent article from Tony Boyd in the Australian Financial Review shone a light on just how active the domestic Australian market has been for M & A activity in 2018. Our last Livewire submission seven months ago touched on a few key things to look out for when trading takeovers and was cautiously optimistic about the outlook of M & A moving forward. Since then, there has been immense opportunity to capitalise on a huge number of deals, and for those that have watched the space from the sidelines for the last six months, the good news is that its showing no signs of slowing down.
The beauty in trading M & A transactions is the low correlation the returns have with the broader indexes. The individual positions are largely insulated from any external swings, as the pricing of the target company is usually a reflection on the likelihood of the deal closing more than anything else. While not entirely devoid of risk (inevitably, not all deals complete as expected), the annualised returns on offer that make the risk/reward compelling, and even more so in a portfolio sense.
Purely as a means of comparison, our lowest risk fund has returned 6.24% so far in 2018 against 1.47% for the XJOAI.
Underpinning the strategy is a high, frequent win rate of small gains. Putting aside any bidding war, and we are fortunate enough to have experienced more than a handful, the upside to the trading takeovers is perceived as limited, with low single digit yields turning off investors in search of larger returns. It certainly doesn’t help that takeover bids can be complex, conditional, and prolonged, and it’s for these reasons we feel the strategy is often overlooked. However, therein lies the opportunity.
In our experience, a takeover generally takes between three and four months on average to complete. With a high win rate, even the returns on a trade with low yield to maturity can compound multiple times within a year and quickly add up to a not immaterial risk adjusted return.
If you know where to look, though, the rewards can be far greater.
Back in February this year, little known gold explorer, Primary Gold (PGO.ASX), received an all cash offer from one of its major shareholders Hanking Australia at 5.75c per share. While admittedly the offer was wrapped in terms and conditions, the share price traded as low as 4.9c, giving an implied return of 17% should the takeover proceed. With such value left on the table, the market was pricing the deal with little chance of success. For those willing to do the work, the conditions weren’t as onerous as the market had priced them to be, and the offer quickly went unconditional in April. Fortunately, we did do the work, and at close the trade had an annualised yield north of 60%.
Sirtex (SRX.ASX) is another trade that we feel was largely overlooked by the market. A scheme of arrangement with Varian was announced at the start of the year at $28 per share. The price immediately jumped to around $27.50 and consequently turned off investors with an implied yield to maturity of only 1.82%. What the market did not count on was an eleventh hour bid from CDH Investments at $33.60 per share, which completely changed the metrics of the transaction (as counterbids almost always do). With the deal still yet to complete and the share price trading well below the $33.60 consideration, there is potentially plenty left on the table.
However, not everything goes to plan.
Readers familiar with Santos (STO.ASX) and Healthscope (HSO.ASX) will know of the highly publicised, private equity backed offers from Harbour Energy and BGH Capital respectively. Both target companies have since walked away from discussions, reminding us all that not every takeover trade is a straight forward winner.
With the right framework (appropriate position sizing, close monitoring of transactions and avoiding deals at the riskier end of the spectrum all included), an M&A focused trading strategy can absorb the trades that don’t work out as expected, while making sure to capitalise on the ones that do. Even with seemingly small returns for each trade, they can soon add up, particularly when M & A activity is surging. BWX, SRX, and even the rebuffed SLK approach are all deals announced just this week adding to the significant number of transactions that have been announce year to date.
We can’t predict the future, but all signs are pointing full steam for continued M&A activity in the months ahead. Our advice to investors is not to sleep on the compelling risk adjusted returns on offer.