Here in the UK, we have seen a massive M&A wave in 2021. Thanks to private equity firms flush with cash, low valuations for UK companies and a relatively cheap Sterling vs the US Dollar, UK small and mid-cap companies have been targeted left, right, and centre. Apart from the usual concerns about foreign takeovers of strategically important businesses, this has also rejuvenated the age-old business of predicting, which company is going to be the next takeover target.
Targeting takeover targets is a siren song that is hard to resist because the returns that can be pocketed on the announcement date of a new takeover are extremely high and can easily surpass 50%. If only there was a way to predict which companies are going to be the next target.
Well, there isn’t. Researchers have tried to identify the driving forces behind a company takeover for more than 50 years now and according to a new review by Abongeh Tunyi from the University of Sheffield we are not only unable to formulate any reliable model that predicts future takeover targets better than chance, we don’t even understand what the driving forces are behind a company becoming a takeover target. Anything from valuation to financial leverage and bankruptcy risk has been examined and researchers have come up empty-handed. In essence, it seems that selecting takeover targets is a more or less random process that has more to do with the psychology of the investor rather than fundamentals.
Yet, both retail and professional investors keep on playing the game. Newspapers write about potential takeover targets and retail investors pile into these stocks in the hope of a quick profit. Professional fund managers may not follow the advice of newspaper journalists and instead use more sophisticated analysis, but they also try to play that game. Though, admittedly, I know of no fund manager who targets takeover targets explicitly. Instead, it is one element of the analysis that may shift the odds in favour of a company. If two companies look equally attractive based on fundamental analysis, the fund manager may invest in the potential takeover target. But even so, targeting takeover targets is a losing game for fund managers. A study of c.2,500 US fund managers and their portfolios showed that the average excess return on takeover targets for fund managers was -0.04% before fees and -1.44% after fees.
Hence, targeting takeover targets is a bit like playing roulette and putting your money on a single number. If you are lucky that number shows up and you strike it rich, but most of the time you will be a loser.