MARKET COMMENT
Profiting From Bids and Takeover Speculation

By Cliff D'Arcy
February 6, 2003

First things first: a strongly worded warning.

The strategy I'm about to describe is dangerous and carries a high "risk of ruin". It involves taking large bets on single shares for short-term gains, which is both unpredictable and speculative. However, taking risks that others avoid can occasionally generate very high returns.

Secondly, I'm annoyed with the Investors Chronicle. Last week, I decided to write an article about my personal experience of betting on takeovers. Then the IC covers the topic in its headline article in last Friday's edition! Never mind, I'll soldier on regardless.

I call my personal strategy "bid vulturing" but the likes of Warren Buffet would call it "takeover arbitrage". The idea is simple: buying the shares of a company that is the subject of strong takeover rumours or, ideally, a formally announced cash or shares bid.

There are five factors you need to consider:

A. the current share price
B. the takeover price (announced or best prediction)
C. the probability that the deal will succeed
D. the likely time to realise your return
E. your worst-case scenario - the downside (loss) if things fall apart.

A and B are fairly easy to obtain, it's C, D and E that tax the mind.

How likely is it that a deal will fall through, which normally causes a sharp drop in the target's share price? If it's a management bid, given their intimate knowledge of the company, a takeover stands a higher-than-average chance of succeeding. Conversely, if an offer's too low, shareholders may reject the deal and you could suffer.

Of course, when an offer is made to acquire a company, the current share price doesn't immediately rise to the offered price. A discount is made for factors C and D above, so it's almost always possible to buy in at a price lower than the expected takeover price. Safeway is an excellent recent example.

Cash offers are best, as they're simpler to value. It's easier to grasp a bid of 25p cash for your shares in William's Washing Machines (WWM) than an offer of 0.25 shares in larger rival Billybob's Spin Driers (BBSD). After all, BBSD's shares go up and down at will, so the value of your holding in WWM is constantly changing.

Fear and greed run amok in takeover situations, hence the high volatility of shares in these circumstances.

Here are three examples of winning deals that I jumped aboard last year, rolling up all the capital into my next deal each time:

Company                    Time in market      % Return *
Abbey National (LSE: ANL)         10 days          24.5%
Arcadia                           20 days          17.1%
Firth Rixson (LSE: FRX)            6 days          11.9%

* before charges

Purists would argue that Firth Rixson is my only true bid arbitrage deal, since it involved buying into a recommended cash offer at a discount. Nevertheless, it's possible to make handsome gains even if a bid is subsequently rejected (Abbey).

Conversely, I've suffered losses when I've lost patience and moved on, or deals fell through. Here are four deals where bids failed to emerge or were rejected:

Gallaher (LSE: GLH)             3.9% loss
PowderJect (LSE: PJP)           ~10% loss
House of Fraser (LSE: HOF)      bought at 77p, now 67.5p (-12.3%), still hold
Holmes Place (LSE: HOL)         bought at 93p, now 72p (-21.5%), still hold

Take care when following this strategy to do your research faultlessly. Even if you have many more losers than winners - as I have had - it's still possible to make substantial gains with nerve, luck and timing.

The writer owns far too many shares in Holmes Place and has a beneficial interest in Abbey National and House of Fraser.