Top Gun FP Client Note: Picking Up Nickels and Dimes In Front Of A Bulldozer

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NOTE: Every week I write a Client Note for my clients.  For a limited time, I am allowing non-clients to sign up and receive the Client Note.  You can sign up at the top right hand corner of the website.  I will also be posting the notes on my blog with a 24-48 hour delay from time to time.  Here is this week’s.
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I’m as befuddled as anyone.  This is a blow-away August.  Yet I can’t call it a trend.
 
Mark Shafir, Global Head of Mergers & Acquisitions at Citigroup
 
I’m an avid golfer, and I have yet to play in August.
 
Robert Profusek, Head of Mergers & Acquisitions at law firm Jones Day
Two Monday’s ago (August 16) computer maker Dell (DELL) reached a deal with cloud storage company 3Par (PAR) to acquire all its outstanding stock for $18 a share in cash ($1.15 billion total) – more than an 80% premium to its Friday close.
 
That Thursday, Intel (INTC) surprised the investment world when it announced a $48 per share, all-cash, deal ($7.65 billion total) to acquire security software maker McAfee (MFE) – a 60% premium to its close the day before.
 
On Monday, Hewlett Packard (HPQ) jumped into the game, trumping Dell by offering $24 a share in cash or $1.6 billion for 3Par.
 
Shareholders of McAfee and 3Par are obviously thrilled and investors have been busy buying up the shares of other potential acquisitions.
 
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This sort of deal making usually gets the market excited but, paradoxically, the S&P has lost about 2.5% since Dell announced its acquisition of 3Par.  In fact, the S&P is close to testing its lows for the year and more than 5% of NYSE traded stocks closed at 52-week lows on Tuesday.  Jim Cramer captured the mood of the market when he wrote “It’s really, really ugly out there.”
 
Individual investors, especially, don’t seem to have much of an appetite for stocks.  After piling into domestic stock mutual funds from 1991 through 2006, investors have pulled almost $300 billion from them since the beginning of 2007, including $33 billion through the first seven months of this year. 
 
Instead, they have been plowing money into bond funds, almost $800 billion since the beginning of 2007, including $185 billion in the first seven months of this year (“In Striking Shift, Small Investors Flee Stock Market”, Graham Bowley, The New York Times , Sunday August 22, A1).
individual-investors-flee-stocks-chart
 
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My strategy is to try to pick up nickels and dimes in front of a bulldozer, as I heard one financial advisor characterize it on CNBC.
 
One strategy I have been employing is buying high dividend paying stocks and then selling out-of-the-money covered calls on them to bring in a little more income.  When most people hear “options”, they think risk.  However, this strategy is extremely conservative as we are the ones selling the options to a buyer who wants to speculate.  We get the option premium up front in exchange for capping our gains on the upside.  I’m happy to make this deal as I don’t see a lot of upside in the near future.  I described this strategy in a Client Note from February: “Top Gun FP Client Note: Two Stocks For A Range Bound Market”, Top Gun FP, February 19, 2010.
 
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Another strategy that I just last week put into effect is known as merger arbitrage.  When a company signs a deal to be acquired, the shares generally rise towards the acquisition price.  However, there is always a risk that the deal won’t get done.  Therefore, the shares usually don’t rise all the way to the deal price.  Sometimes they do, or even higher, if investors think another, higher bid is likely.
 
That’s where merger arbitragers come into play.  They will buy up the shares, hoping to profit from the difference between the market price and the deal price.  For instance, let’s say a stock is trading at $25 when it is announced that the company is to be acquired for $30.  The stock will rise towards the deal price, say $29.  At that point, most shareholders will be happy to sell and move on.  Merger arbitragers will buy the shares from them and take the extra $1 when the deal closes. 
 
It might not seem like a lot but it can be a safe and profitable strategy.  $1 on a $29 investment is only 3.5%.  However, in most cases it does not take a full year for a deal to close.  If it takes only 6 months, this means a 7% annualized return.  If it takes only 4 months, the annualized return increases to almost 11%.  Add in leverage and the returns can be amplified.  Finally, there is always the possibility of a higher bid coming in, further boosting returns.
 
Of course, there is the risk that the deal falls apart.  In this case, the stock generally collapses back down to the pre-acquisition trading price and the arbitrager can take quite a hit.
 
With a number of mergers being announced in the last couple of weeks, there are some opportunities here.  For example, Intel signed a deal to acquire McAfee for $48 a share last Thursday.  McAfee’s shares closed that day at $47 and continue to trade around that level.  That reflects the risk the deal might not get done.
 
In this case, however, the odds are extremely high that the deal will go through.  Intel has more than $12 billion in cash, cash equivalents and short term securities on its balance sheet – more than enough to pay the $7.65 billion to acquire McAfee.  They may very well get some financing because of the low rates currently available, but they don’t need it.
 
The price represents a 60% premium to McAfee’s closing price the day before and is higher than McAfee shares have traded at any point in time since early 1999.  McAfee shareholders are likely to approve the deal.
 
I also think the deal is likely to get done by the end of the year.  The Bush tax cuts expire at the end of the year and the capital gains tax rate will increase from 15% to 20%.  That means extra capital gains taxes for McAfee shareholders.  They are likely to push to close the deal before year end to avoid higher capital gains taxes.
 
Finally, there is the possibility – though remote – of a higher bid.  Cisco, Microsoft, Hewlett Packard, Google and Apple all have plenty cash on their balance sheet to do a deal.  Perhaps they will come in with a higher offer.
 
A $1 return on a $47 investment equals 2.13%.  If I’m right that the deal gets done by the end of the year, that means a 4-month holding period and a 6.5% annualized return.  I have been holding a lot of cash in client accounts due to market conditions and this represents a significantly better return than we have been getting on that cash. 
 
There are risks but there is also the possibility of more upside.  It strikes me as a good way to try to pick up some nickels and dimes in front of a bulldozer.
 
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Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
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Granite Bay CA 95746
(916) 224-0113
 
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