The last 48 hours has seen global equity markets, including the S&P/ASX 200 (INDEXASX: XJO) (^AXJO), correct sharply, sparking fears that the decade-long bull market may finally be shifting gear. One might argue this should hardly come as a surprise and is long overdue.
But what can investors caught in the downdraft do now?
We believe the best form of protection against a market downturn is to remove market exposure from the equation. This does not mean avoiding using equity markets altogether, but rather seeking out opportunities that are heavily insulated from market movements yet have a favourable risk/reward tradeoff. Nowhere is this better exemplified than in strategies focusing on merger arbitrage and other ‘special situations’, where compelling risk-adjusted returns are frequently on offer.
A significant benefit of focusing on M&A, in particular, is the inherent market neutrality of returns that such opportunities – if carefully selected – can provide. Securities subject to certain takeover offers are generally insulated from the broader market impact as the price of these securities are driven by factors specific to the bid and not the market generally.
“A significant benefit of focusing on M&A, in particular, is the inherent market neutrality of returns that such opportunities – if carefully selected – can provide.”
At the extreme, an unconditional takeover bid scheduled (and expected) to successfully close in a short timeframe will experience low volatility in the lead up to completion, as the share’s future value (disregarding the potential for a counter bid) is already known and the level of the broader market is therefore unimportant.
Takeovers that remain less binding (and therefore less certain) will typically trade between the undisturbed price, that being the price of the security prior to any announcement of a change of control transaction, and the consideration price of the offer.
The share price activity between these two price points is a proxy for the probability of the transaction completing: the closer the share price trades to the offer price, the more likely the market perceives the transaction to go ahead. It follows that this probability estimation is subjective, and the deviation between subjective and objective estimations leads to mispricing and opportunity.
By way of an example, Navitas Limited (ASX: NVT) announced on Tuesday the receipt of a preliminary, non-binding proposal from a private equity-led consortium at a consideration of $5.50 per share, a 26% premium to the previous close of $4.35.
Shares converged on the offer price and traded in a range from $5.22 to as high as $5.56, above the offer price, before closing out the day at $5.30. Importantly, we note the opportunity for good active management here – throughout the course of the day, the underlying probability of the transaction completing did not change significantly enough to justify such large volatility in the share price.
Having significant experience in this space and a firm grasp of the mechanics of takeover transactions is key to determining when the market pricing probability deviates from the true probability. Paying above the consideration price of $5.50 (as happened on Tuesday) not only leaves little margin of error for a failed transaction but also contemplates a successful higher proposal emerging.
“Having significant experience in this space and a firm grasp of the mechanics of takeover transactions is key to determining when the market pricing probability deviates from the true probability. “
Buying around the close level of $5.30 provides a margin of safety and optionality over a competing proposal emerging without a commensurate increase in risk. This is not to say that we think NVT is fair value around these levels, but an illustration of the dynamic mechanics behind a takeover trade.
Highlighting the inherent and potential market neutrality of merger arbitrage, the ASX 200 was down 2.74% on Thursday close of trade, while NVT was effectively flat (down just 0.19%) while exhibiting much lower intraday volatility.
NVT is not alone in this regard. Other stocks under takeover such as Scottish Pacific (ASX: SCO), Zenitas Healthcare (ASX: ZNT), and Folkestone Limited (ASX: FLK) finished -0.23%, -0.35% and flat respectively, all traded within narrow ranges.
Overall, our funds focussed on M&A actually finished up on the day – something that has historically proven to be a common occurrence when markets experience a sharp selloff. This is not often appreciated by investors who can sometimes think about merger arbitrage as being speculative in nature (it can be, but needn’t be) or having more market exposure than it does. Our market exposure or beta is not positive – it is 0.
This is not to say that an M&A strategy is devoid of downside risk; transactions can and do fall over. However, importantly these risks are frequently independent of market direction, providing genuine diversification and idiosyncratic risks to investors portfolios which are hard to find elsewhere.
Screening criteria, strict rules around position sizing, constant monitoring and risk management, and a focus on minimising downside risk is key to successfully executing an M&A oriented strategy. It may be a relatively simple and transparent strategy (and this is a good thing), but that does not mean it is easy to execute well.
There are few alternative strategies which offer genuine diversification, strong returns and protection against market downturns (both short-term volatility and over a longer time frame), but a well executed M&A strategy is one that does. The golden rule of making money is to not lose it in the first place.
This article contains general information only and is issued by Harvest Lane Asset Management, Corporate Authorised Representative number: 433046. The information does not take into account your needs, goals or objectives. Therefore, you should speak to a qualified financial adviser before acting on the information.