Learn three smart ways to profit from mergers

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Mergers and acquisitions are increasing in all sectors as confidence in the economy improves.

With company prices relatively low and private equity firms closed, corporations with access to capital are making strategic acquisitions to strengthen their competitive positions.

Last week, Agilent Technologies (A) agreed to buy Varian for $ 1.5 billion. Also on the technology front, International Business Machines (IBM) agreed to buy Chicago-based predictive analytics software provider SPSS (SPSS) for $ 1.2 billion.

In the healthcare sector, France’s Sanofi Aventis (SNY) is disbursing $ 4 billion to Merck (MRK) to take full control of its 50% Merial animal health joint venture. Sanofi is also buying India-based vaccine maker Shantha Biotechnics for $ 781 million.

In energy, the gas pipeline operator Targa Resources Partners (NGLS) is acquiring the natural gas liquids business of Targa Resources for $ 530 million. Wireless service provider Sprint Nextel (S) is buying Virgin Mobile USA (VM) for $ 420 million. In airlines, Southwest Airlines (LUV) has entered the ring with the intention of surpassing Republic Airways (RJET) and acquiring the distressed airline Frontier Airlines (FRNTQ.PK).

The increase in the number of mergers and acquisitions is providing investors with unique ways to profit from such activities.

Benefit from mergers and acquisitions

One way to benefit from increased M&A activity is to take long positions on potential targets. The second way is to capture the differential between the final price paid by the acquirer for the acquisition objective and the current market price for the objective. This spread arises because the target shares are often traded at a discount to the offer price. The magnitude of the spread depends on factors such as the uncertainty associated with the deal, interest rates, and investors’ appetite for risk. The above two methods are usually more suitable for institutional investors.

A less common, but effective way for retail investors to benefit from M&A action is by buying shares in investment banks that can benefit from increased M&A. Goldman Sachs (GS) and Morgan Stanley (MS) are examples of investment banks that are independently listed in the US These companies, along with European banks such as Credit Suisse Group (CS) and Deutsche Bank (DB), have extensive experience in sectors such as healthcare and geographic regions such as Asia, which promise increased M&A activity.

The credit crisis has also allowed certain commercial banks to strengthen their investment banking capabilities. Bank of America (BAC), JP Morgan Chase (JPM) and Wells Fargo (WFC) are relatively well positioned to make a significant portion of their M&A profits. However, exposure to residential and commercial real estate can negatively affect the share price performance of these banks.

Mutual Fund and ETF Investors

Investors looking for packaged products that can benefit from mergers and acquisitions have a few options to choose from.

Mutual funds include Fidelity Select Brokerage & Investment Management (FSLBX) and The Merger Fund (MERFX).

FSLBX is more of a conventional vehicle that targets investment banks, asset managers, and exchanges. MERFX is somewhat unconventional in the sense that it seeks to profit from arbitrage spreads.

ETF investors can check out SPDR KBW Capital Markets (KCE), iShares Dow Jones US Broker-Dealers (IAI), and Claymore / Clear Global Exchanges, Brokers & Asset Managers (EXB). While KCE and IAI do not include foreign companies, EXB invests in companies around the world.

In 2009, all previous investments except MERFX have easily outperformed the S&P 500. MERFX has gained about half the S&P 500 with much less volatility than the benchmark.

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