The Verdict on Market Timing

Many professional investors move money from cash to equities or to long term bonds on the basis of their forecasts of fundamental economic conditions.  This is one reason many brokers give to support their belief in professional money management.

John Bogle, founder of the Vanguard Group of Investment Companies said, "In 30 years in this business, I do not know anybody who has done it successfully and consistently, not anybody who knows anybody who has done it successfully and consistently.  Indeed, my impression is that trying to do market timing is likely, not only not to add value to your investment program, but to be counterproductive."

Over a fifty-four year period, the market has risen in 36 years, been even in 3 years and declined in only 15 years.  Thus, the odds of being successful when you are in cash rather than stocks are almost 3 to 1 against you.

An academic study by Professors Richard Woodward and Jess Chua of the University of Calgary shows that holding on to your stocks as long-term investments works better than market timing because your gains from being in stocks during bull markets far outweigh the losses in bear markets.  The professors conclude that a market timer would have to make correct decisions 70 percent of the time to outperform a buy-and-hold investor.  Have you met anyone who can bat 0.700 in calling market turns?


An examination of how mutual funds have varied their cash positions in response to their changing views about the relative attractiveness of equities.

Mutual fund managers have been incorrect in their allocation of assets into cash in essentially every recent market cycle.

Caution on the part of mutual-fund managers (as represented by a very high cash allocation) coincides almost perfectly with troughs in the stock market.

• Peaks in mutual funds' cash positions have coincided with market troughs during 1970, 1974, 1982, and the end of 1987 after the great stock-market crash. 
• Another peak in cash positions occurred in late 1990, just before the market rallied during 1991, and in 1994, just before the greatest six-year rise in stock prices in market history.
• Cash positions were also high in late 2002 and in March 2009, at the trough of the market.

Conversely, the allocation to cash of mutual-fund managers was almost invariably at a low during peak periods in the market.

• For example, the cash position of mutual funds was near an all-time low in March 2000, just before the market began its sharp decline.  

The ability of mutual-fund managers to time the market has been egregiously poor.  

Ref: A Random Walk Down Wall Street by Burton G. Malkiel

Two ways to profit from the market swings: Timing or Pricing

Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which  he may try to do this:

• the way of timing and 
• the way of  pricing.

By timing we mean the endeavour to anticipate the action of the stock market—

• to buy or hold when the future course is deemed to be upward, 
• to sell or refrain from buying when the course is downward. 

By pricing we mean the endeavour

• to buy stocks when they are quoted below their fair value and 
• to sell them when they rise above such value. 

A less ambitious form of pricing is  the simple effort

• to make sure that when you buy you do not  pay too much for your stocks. 
• This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as  such it represents an essential minimum of attention to market levels.

We are convinced that the intelligent investor can derive satisfactory results from pricing of either type. 

We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator’s financial results. 

8 Buffett Secrets for Investing in Banks

By Matt Koppenheffer
November 29, 2012

Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) Warren Buffett is seen by many as one of the best investors of our time. But he's also often seen as particularly insightful when it comes to investing in banks.

Certainly Berkshire shareholders should hope that the latter is the case as the company owns 8% of banking giant Wells Fargo  (NYSE: WFC  ) along with $5 billion in Goldman Sachs  (NYSE: GS  ) , nearly $2 billion of US Bancorp  (NYSE: USB  ) stock, and roughly another $1 billion between M&T Bank  (NYSE: MTB  ) and Bank of New York Mellon  (NYSE: BK  ) . Not to mention $5 billion in preferred shares of Bank of America (NYSE: BAC  ) .

So what does Warren know that makes him so prescient when it comes to banks?

1. Owning a bank can be a long-term endeavor.
The banking business is a cyclical one, but bank ownership for Buffett typically isn't. In 1969, Berkshire acquired Illinois National Bank and Trust Company and held onto it until it was forced by regulators to sell the bank in 1980. The company's ownership position in Wells Fargo goes back to 1989, while the stake in M&T Bank dates back to at least 1999.

2. Management matters.
We've seen from the financial crisis how reckless management can lead to outright disaster. When Buffett talks about the banks he's owned, he's generally taking time to praise management. Here's what he had to say in Berkshire's 1990 shareholder letter when praising Wells Fargo's management:

[The team at Wells Fargo pays] able people well, but abhor having a bigger head count than is needed... attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, [they] stick with what they understand and let their abilities, not their egos, determine what they attempt.

3. Leverage kills.
Again from the 1990 shareholder letter:

When assets are twenty times equity-a common ratio in this industry-mistakes that involve only a small portion of assets can destroy a major portion of equity. ... Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.

4. Panic? Not a chance.
Rather than panic during banking downturns, Buffett has used them to build his ownership stakes. The original stake in Wells Fargo was purchased between late 1989 and early 1990 -- when banks were faltering during the previous banking crisis. During the latest meltdown, Buffett upped Berkshire's ownership in Wells Fargo and US Bancorp, maintained the company's position in M&T Bank, and famously provided preferred-share financing to Goldman. Just last year he sunk $5 billion into Bank of America when it was facing a market freak-out.

The fact that Wells Fargo's price fell after Berkshire initially bought didn't phase Buffett one bit:

Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices. Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. 

In case you're wondering, yes, this is that classic Buffett "be greedy when others are fearful" sentiment.

5. Know where to look for performance.
As Marty Whitman puts it: "Rarely do more than three or four variables really count. Everything else is noise." 

Three things that Buffett has highlighted when it comes to evaluating a bank are: return on assets, risk (leverage ratio), and expenses (efficiency ratio).

6. Remember to own for a long time.
There's no reason to not mention this one twice, because it's an important one. To have a year where an attractive bank he owned made no profit "would not distress us." Instead, "at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity."

7. Pick your spots to go outside the box.
With all of this in mind (especially the risk part), Goldman Sachs may not seem like a very Buffett-esque bank to invest in. And it's really not. However, when we think about the investment banks that Berkshire could have invested in -- Bear Stearns, Lehman Brothers, Morgan Stanley  (NYSE: MS  ) , etc. -- Goldman stands out as head and shoulders above the rest.

Not to mention that Buffett was no stranger to Goldman. In Berkshire's 2003 shareholder letter, you can find Buffett singing the praises of -- believe it or not -- a Goldman Sachs investment banker:

I should add that Byron [Trott] has now been instrumental in three Berkshire acquisitions. He understands Berkshire far better than any investment banker with whom we have talked and – it hurts me to say this – earns his fee.

8. Don't get all mushy over the whole thing.
It's certainly possible to find great banks to invest in and Buffett has found his fair share for Berkshire. But banking ain't an easy slog, and even Buffett will admit he's not going out of his way for a bank unless it's really worthwhile. As he put it: "The banking business is no favorite of ours."

Buffett picks 'em, and you benefit

You can, of course, take the above points and use them to help you find great banks to invest in. Or, you could leave the picking to Warren and simply invest in Berkshire Hathaway. But is now the best time to be buying Berkshire?

http://www.fool.com/investing/general/2012/11/29/8-buffett-secrets-for-investing-in-banks.aspx

What are the risks in buying call warrants?

Wednesday August 11, 2010

Personal Investing - By Ooi Kok Hwa

Prices are influenced by intrinsic value and time value

Besides, a lot of investors have been complaining that they are unable to make money from the call warrants that they have bought.LATELY, we notice that there are growing numbers of call warrants getting listed on Bursa Malaysia. Even though there are many call warrants issued and traded in the market, the trading volumes of these call warrants are relatively low compared with the normal warrants.

Many investors cannot differentiate between a warrant and a call warrant.

A warrant is a transferable option certificate issued by a company which entitles the holder to buy a specific number of shares in that company at a specific price (or exercise price) at a specific time in the future. It is normally issued by a listed company.

A call warrant (like a call option) also gives investors a right to buy stocks in a company within a fixed period of time. However, warrants are issued by listed companies whereas call warrants are issued by investment banks.

An investor monitoring share prices at a private stock market gallery in Kuala Lumpur. Many investors have been complaining that they are unable to make money from the call warrants that they have bought.

If investors exercise the rights in warrants, they will receive the listed companies’ shares.

Meanwhile, upon maturity of call warrants, investment banks will only pay investors in cash if the closing price of the listed companies is higher than the exercise price of the call warrants. Investors will get nothing if the closing price of the listed companies is lower than the exercise price.

There are many risks in buying into call warrants. Call warrants have shorter maturity period as compared to warrants. Normally, warrants have maturity period of five years or more whereas call warrants have very short maturity period of less than a year.

In many instances, investors who have bought into these call warrants do not realise that their call warrants have expired. Nevertheless, call warrants will be automatically exercised upon the maturity date if the settlement price is higher than the exercise price.

As mentioned earlier, a lot of call warrants are not actively traded in the market. In fact, a majority of them do not have trading volume on a daily basis. We believe one of the possible reasons is that some of these call warrants are getting nearer to maturity date.

The prices of call warrants are influenced by their intrinsic value and time value.

If the call warrants are getting nearer to their maturity date, the time value will be closer to zero. In addition, if the mother price of the listed companies is being traded at a lower price than the exercise price plus the premium that the investors have paid for the call warrant, the market price of these call warrants will fall below their original issue price.

For those who have subscribed into these call warrants, rather than cutting losses and selling them into the market, they will likely hold on to the call warrants and hope that the mother price will recover one day. Unfortunately, in many instances, investors get nothing upon maturity of these call warrants.

Given that the gap between the buying and selling prices is quite big for some call warrants, many investors find it difficult to buy or sell the call warrants. Hence the fact that call warrants usually have low trading volume implies that this is an instrument with very high liquidity risks.

The main reason for a lot of investors to purchase call warrants is the hope of getting payments from investment banks. However, investors need to understand that the majority of the call warrants are European-styled, which means investors cannot exercise them before the maturity date.

The majority of call warrants are settled in cash for the difference between closing price and exercise price. The formula for cash settlement amount is equal to the number of call warrants x (closing price – exercise price) x 1/exercise ratio. Hence, investors need to pay attention to the exercise price, exercise ratio and premium that they have paid.

For example, the exercise price on Call Warrant Company A (Company A CA) is RM10, the exercise ratio is 10 Company A CA to 1 Company A share and the premium investors need to pay is 10 sen for each Company A CA. To the call warrant holders, in order to breakeven, the mother share price of Company A needs to go higher than RM11 or RM10 plus RM1 (10x10 sen, which is the total premium that they have paid).

Lastly, investors need to pay attention to the fundamentals of the mother companies and check the potential price appreciations for these companies.

Companies with good prospects will have higher possibilities of price appreciation and therefore lower risk of buying into the call warrants.

Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.

http://biz.thestar.com.my/news/story.asp?sec=business&file=/2010/8/11/business/6832498

The Technique of Fundamental Analysis

Fundamental analysts believe that the market is 90% logical and only 10% psychological.  Value is related to a company's assets, its expected growth rate of earnings and dividends, interest rates, and risk.  By studying these factors, the fundamentalist arrives at an estimate of a security's intrinsic value or firm foundation of value.

Fundamentalists believe that eventually the market will reflect the security's real worth.

The fundamentalist strives to be relatively immune to the optimism and pessimism of the crowd and makes a sharp distinction between a stock's current price and its true value.

In estimating the firm-foundation value of a stock, the fundamentalist's most important job is to estimate the firm's future stream of earnings and dividends.  The worth of a share is taken to be the present or discounted value of all the cash flows the investor is expected to receive.  The analyst must estimate the firm's sales level, operating costs, tax rates, depreciation, and the sources and costs of its capital requirements.

The fundamentalist uses four basic determinants to help estimate the proper value for any stock.

1.  The expected growth rate.
Rule:  A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.
Rule:  A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.

2.  The expected dividend payout.
Rule:  A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company;s earnings that is paid out in cash dividends.

3.  The degree of risk.
Rule:  A rational (and risk averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company's stock.

4.  The level of market interest rates.
Rule:  A rational investor should be willing to pay a higher price for a share, other things being equal, the lower the interest rates.


The above valuation rules imply that a security's firm-foundation value (and its price-earnings multiple) will be higher 

• the larger the company's growth rate and the longer its duration;
• the larger the dividend payout for the firm; 
• the less risky the company's stocks; and 
• the lower the general level of interest rates.

In principle, such rules are very useful in suggesting a rational basis for stock prices and in giving investors some standard of value.  But before using these rules, bear in mind the following caveats.

1.  Expectations about the future cannot be proven in the present.

Predicting future earnings and dividends is a most hazardous occupation.  It is extremely difficult to be objective; wild optimism and extreme pessimism constantly battle for top place. "Forecasts are difficult to make - particularly those about the future."

2.  Precise figures cannot be calculated from undetermined data.

There is always some combination of growth rate and growth period that will produce any specific price.  In this sense, it is intrinsically impossible, given human nature, to calculate the intrinsic value of a share.  

The point to remember is that the mathematical precision of fundamental value formulas is based on treacherous ground: forecasting the future.  "God Almighty does not know the proper price-earnings multiple for a common stock."

3.  What's growth for the goose is not always growth for the gander.

It is always true that the market values growth, and that higher growth rates and larger multiples go hand in hand.  But the crucial question is:  How much more should you pay for higher growth?  

There is no consistent answer.  In some periods, the market was willing to pay an enormous price for stocks exhibiting high growth rates.  At other times, high growth stocks commanded only a modest premium over the multiples of common stocks in general.   Growth can be as fashionable as tulip bulbs, as investors in growth stocks painfully learned. 

From a practical standpoint, the rapid changes in market valuations that have occurred suggest that it would be very dangerous to use any one year's valuation relationships as an indication of market norms.  However, by comparing how growth stocks are currently valued with historical precedent, the investor should at least be able to isolate those periods when a touch of the tulip bug has smitten investors.

Why might fundamental analysis fail to work?

There are three potential flaws in this type of analysis.
1.  The information and analysis may be incorrect.
2.  The security analyst's estimate of "value" maybe faulty.
3.  The market may not correct its "mistakes", and the stock price may not converge to its value estimate.

Pavilion REIT Chairman Lim reported to be worth RM3bil

Friday November 23, 2012

KUALA LUMPUR: Desmond Lim Siew Choon became a billionaire developing a high-end retail mall and an office tower in Kuala Lumpur, wooing Middle Eastern investors and listing the properties as a real estate investment trust.

The 52-year-old chairman of Pavilion Real Estate Investment Trust, Malaysia's second-biggest property trust by market value, is worth at least US$1bil (RM3.06bil), according to the Bloomberg Billionaires Index. Lim and his wife, Tan Kewi Yong, own 38% of the Kuala Lumpur-based trust, whose shares have outpaced other companies that raised at least US$50mil in an initial public offering (IPO) in Malaysia in the past 12 months.

Rising consumption and increased tourism in Malaysia have bolstered Pavilion REIT, which has surged almost 60% since trading on Dec 7. Malaysia's gross domestic product exceeded 5% for at least a fifth quarter as the Government raised spending and unveiled infrastructure projects before a general election that must be held by early 2013.

“While the general masses have benefited from this wealth effect, I would say that the upper crust would have seen the largest gains from the recent run up,” said William Chan, chief executive officer of Singapore-based family office Stamford Privee. “Connections matter, both locally and globally.”

Lim, who has never appeared on an international wealth ranking, declined to be interviewed as he was travelling for business, said Philip Ho, chief executive officer of Pavilion REIT Management Sdn, which manages the property trust.

Lim majored in finance at the University of Central Oklahoma, and started building houses, condominiums and office towers with developerKhuan Choo Group in the 1980s. As Malaysia prodded banks to merge, Lim took over the listing status of Gadek Capital Bhd after the latter sold its finance business to Hong Leong Bank Bhd in 2000. Lim injected Khuan Choo into Gadek, renamed it Malton Bhd and relisted it in 2002.

The billionaire made the bulk of his fortune from developing the mixed-use Pavilion project a mall, two luxury apartment towers and an office building on the former site of a girls' school in Kuala Lumpur, one of the last pieces of prime real estate in the capital.

Malton was the contractor of the Pavilion, located in the main shopping street of Jalan Bukit Bintang, Kuala Lumpur's version of Fifth Avenue in New York and Orchard Road in Singapore. In the heart of the city's Golden Triangle entertainment and commercial district, the mall, which drives the property trust's earnings, is surrounded by hotels including the Westin Kuala Lumpur and JW Marriott Hotel. Tourists account for more than 30% of Pavilion's shoppers. Malaysia attracted 24.7 million tourists last year, almost double the 12.7 million in 2001.

The mall, which has total net lettable retail area of more than 1.3 million sq ft, houses boutiques including Prada and Hermes alongside luxury-car showrooms offering the latest Jaguar and Bentley models. Other tenants include The Loaf, a Japanese-style gourmet bakery and bistro part-owned by former Malaysian prime minister Mahathir Mohamad, as well as an art gallery promoting the works of American pop artist Robert Indiana and contemporary painters.

According to a newsreport, when Lim embarked on the project around 2002, his entry cost was low with commercial and residential properties in downtown Kuala Lumpur transacting at less than RM500 per sq ft. Prices had risen more than three times to about RM1,800 per sq ft by the time it was completed in 2008.

There is an “increasing scarcity of prime land” in the capital's city centre, particularly in the Golden Triangle area, the research unit of Kuala Lumpur-based Alliance Investment Bank Bhd said in a report dated July 25.

Kuwait Finance House, the Persian Gulf state's biggest Islamic lender, helped to finance the development cost when it took a 49% stake in the Pavilion project in 2006 and bought both the residential towers. Qatar Investment Authority has since bought the stake from Kuwait Finance House and owns about 36% of Pavilion REIT.

Lim and his wife received about RM703mil in cash from selling their stakes in the Pavilion Kuala Lumpur Mall and the office tower to the trust before its initial share sale, according to Bloomberg calculations. They were also paid in equity and are the biggest shareholders in Pavilion REIT, along with Qatar's sovereign wealth fund.

“The turning point for him is through this development project,” said Ang Kok Heng, chief investment officer at Phillip Capital Management Sdn in Kuala Lumpur. “He's been keeping a very low profile; not many people know much about him.”- Bloomberg

Mergers and Acquisitions: Why They Can Fail

It's no secret that plenty of mergers don't work. Those who advocate mergers will argue that the merger will cut costs or boost revenues by more than enough to justify the price premium. It can sound so simple: just combine computer systems, merge a few departments, use sheer size to force down the price of supplies and the merged giant should be more profitable than its parts. In theory, 1+1 = 3 sounds great, but in practice, things can go awry.

Historical trends show that roughly two thirds of big mergers will disappoint on their own terms, which means they will lose value on the stock market. The motivations that drive mergers can be flawed and efficiencies from economies of scale may prove elusive. In many cases, the problems associated with trying to make merged companies work are all too concrete.

Flawed Intentions
For starters, a booming stock market encourages mergers, which can spell trouble. Deals done with highly rated stock as currency are easy and cheap, but the strategic thinking behind them may be easy and cheap too. Also, mergers are often attempt to imitate: somebody else has done a big merger, which prompts other top executives to follow suit.

A merger may often have more to do with glory-seeking than business strategy. The executive ego, which is boosted by buying the competition, is a major force in M&A, especially when combined with the influences from the bankers, lawyers and other assorted advisers who can earn big fees from clients engaged in mergers. Most CEOs get to where they are because they want to be the biggest and the best, and many top executives get a big bonus for merger deals, no matter what happens to the share price later.

On the other side of the coin, mergers can be driven by generalized fear. Globalization, the arrival of new technological developments or a fast-changing economic landscape that makes the outlook uncertain are all factors that can create a strong incentive for defensive mergers. Sometimes the management team feels they have no choice and must acquire a rival before being acquired. The idea is that only big players will survive a more competitive world.

The Obstacles to Making it Work
Coping with a merger can make top managers spread their time too thinly and neglect their core business, spelling doom. Too often, potential difficulties seem trivial to managers caught up in the thrill of the big deal.

The chances for success are further hampered if the corporate cultures of the companies are very different. When a company is acquired, the decision is typically based on product or market synergies, but cultural differences are often ignored. It's a mistake to assume that personnel issues are easily overcome. For example, employees at a target company might be accustomed to easy access to top management, flexible work schedules or even a relaxed dress code. These aspects of a working environment may not seem significant, but if new management removes them, the result can be resentment and shrinking productivity. More insight into the failure of mergers is found in the highly acclaimed study from McKinsey, a global consultancy. The study concludes that companies often focus too intently on cutting costs following mergers, while revenues, and ultimately, profits, suffer. Merging companies can focus on integration and cost-cutting so much that they neglect day-to-day business, thereby prompting nervous customers to flee. This loss of revenue momentum is one reason so many mergers fail to create value for shareholders.

But remember, not all mergers fail. Size and global reach can be advantageous, and strong managers can often squeeze greater efficiency out of badly run rivals. Nevertheless, the promises made by deal makers demand the careful scrutiny of investors. The success of mergers depends on how realistic the deal makers are and how well they can integrate two companies while maintaining day-to-day operations.


Read more: http://www.investopedia.com/university/mergers/mergers5.asp#ixzz2CuCDdkQf


Mergers and Acquisitions: Conclusion


One size doesn't fit all. Many companies find that the best way to get ahead is to expand ownership boundaries through mergers and acquisitions. For others, separating the public ownership of a subsidiary or business segment offers more advantages. At least in theory, mergers create synergies and economies of scale, expanding operations and cutting costs. Investors can take comfort in the idea that a merger will deliver enhanced market power.

By contrast, de-merged companies often enjoy improved operating performance thanks to redesigned management incentives. Additional capital can fund growth organically or through acquisition. Meanwhile, investors benefit from the improved information flow from de-merged companies.

M&A comes in all shapes and sizes, and investors need to consider the complex issues involved in M&A. The most beneficial form of equity structure involves a complete analysis of the costs and benefits associated with the deals.

Let's recap what we learned in this tutorial:
A merger can happen when two companies decide to combine into one entity or when one company buys another. An acquisition always involves the purchase of one company by another.
The functions of synergy allow for the enhanced cost efficiency of a new entity made from two smaller ones - synergy is the logic behind mergers and acquisitions.
Acquiring companies use various methods to value their targets. Some of these methods are based on comparative ratios - such as the P/E and P/S ratios - replacement cost or discounted cash flow analysis.
An M&A deal can be executed by means of a cash transaction, stock-for-stock transaction or a combination of both. A transaction struck with stock is not taxable.
Break up or de-merger strategies can provide companies with opportunities to raise additional equity funds, unlock hidden shareholder value and sharpen management focus. De-mergers can occur by means of divestitures, carve-outs spinoffs or tracking stocks.
Mergers can fail for many reasons including a lack of management foresight, the inability to overcome practical challenges and loss of revenue momentum from a neglect of day-to-day operations.


Read more: http://www.investopedia.com/university/mergers/mergers6.asp#ixzz2CuCU4UdQ

Break Ups (De-mergers): Sell-off, Carve-out, Spin-off and Tracking stocks

Mergers and Acquisitions: Break Ups


As mergers capture the imagination of many investors and companies, the idea of getting smaller might seem counterintuitive. But corporate break-ups, or de-mergers, can be very attractive options for companies and their shareholders.

Advantages
The rationale behind a spinoff, tracking stock or carve-out is that "the parts are greater than the whole." These corporate restructuring techniques, which involve the separation of a business unit or subsidiary from the parent, can help a company raise additional equity funds. A break-up can also boost a company's valuation by providing powerful incentives to the people who work in the separating unit, and help the parent's management to focus on core operations.

Most importantly, shareholders get better information about the business unit because it issues separate financial statements. This is particularly useful when a company's traditional line of business differs from the separated business unit. With separate financial disclosure, investors are better equipped to gauge the value of the parent corporation. The parent company might attract more investors and, ultimately, more capital.

Also, separating a subsidiary from its parent can reduce internal competition for corporate funds. For investors, that's great news: it curbs the kind of negative internal wrangling that can compromise the unity and productivity of a company.

For employees of the new separate entity, there is a publicly traded stock to motivate and reward them. Stock options in the parent often provide little incentive to subsidiary managers, especially because their efforts are buried in the firm's overall performance.

Disadvantages
That said, de-merged firms are likely to be substantially smaller than their parents, possibly making it harder to tap credit markets and costlier finance that may be affordable only for larger companies. And the smaller size of the firm may mean it has less representation on major indexes, making it more difficult to attract interest from institutional investors.

Meanwhile, there are the extra costs that the parts of the business face if separated. When a firm divides itself into smaller units, it may be losing the synergy that it had as a larger entity. For instance, the division of expenses such as marketing, administration and research and development (R&D) into different business units may cause redundant costs without increasing overall revenues.

Restructuring Methods
There are several restructuring methods: doing an outright sell-off, doing an equity carve-out, spinning off a unit to existing shareholders or issuing tracking stock. Each has advantages and disadvantages for companies and investors. All of these deals are quite complex.

Sell-Offs
A sell-off, also known as a divestiture, is the outright sale of a company subsidiary. Normally, sell-offs are done because the subsidiary doesn't fit into the parent company's core strategy. The market may be undervaluing the combined businesses due to a lack of synergy between the parent and subsidiary. As a result, management and the board decide that the subsidiary is better off under different ownership.

Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to pay off debt. In the late 1980s and early 1990s, corporate raiders would use debt to finance acquisitions. Then, after making a purchase they would sell-off its subsidiaries to raise cash to service the debt. The raiders' method certainly makes sense if the sum of the parts is greater than the whole. When it isn't, deals are unsuccessful.

Equity Carve-Outs
More and more companies are using equity carve-outs to boost shareholder value. A parent firm makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partial sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly traded subsidiary.

A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing faster and carrying higher valuations than other businesses owned by the parent. A carve-out generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks the value of the subsidiary unit and enhances the parent's shareholder value.

The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent retains some control. In these cases, some portion of the parent firm's board of directors may be shared. Since the parent has a controlling stake, meaning both firms have common shareholders, the connection between the two will likely be strong.

That said, sometimes companies carve-out a subsidiary not because it's doing well, but because it is a burden. Such an intention won't lead to a successful result, especially if a carved-out subsidiary is too loaded with debt, or had trouble even when it was a part of the parent and is lacking an established track record for growing revenues and profits.

Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can arise as managers of the carved-out company must be accountable to their public shareholders as well as the owners of the parent company. This can create divided loyalties.

Spinoffs
A spinoff occurs when a subsidiary becomes an independent entity. The parent firm distributes shares of the subsidiary to its shareholders through a stock dividend. Since this transaction is a dividend distribution, no cash is generated. Thus, spinoffs are unlikely to be used when a firm needs to finance growth or deals. Like the carve-out, the subsidiary becomes a separate legal entity with a distinct management and board.

Like carve-outs, spinoffs are usually about separating a healthy operation. In most cases, spinoffs unlock hidden shareholder value. For the parent company, it sharpens management focus. For the spinoff company, management doesn't have to compete for the parent's attention and capital. Once they are set free, managers can explore new opportunities.

Investors, however, should beware of throw-away subsidiaries the parent created to separate legal liability or to off-load debt. Once spinoff shares are issued to parent company shareholders, some shareholders may be tempted to quickly dump these shares on the market, depressing the share valuation.

Tracking Stock
A tracking stock is a special type of stock issued by a publicly held company to track the value of one segment of that company. The stock allows the different segments of the company to be valued differently by investors.

Let's say a slow-growth company trading at a low price-earnings ratio (P/E ratio) happens to have a fast growing business unit. The company might issue a tracking stock so the market can value the new business separately from the old one and at a significantly higher P/E rating.

Why would a firm issue a tracking stock rather than spinning-off or carving-out its fast growth business for shareholders? The company retains control over the subsidiary; the two businesses can continue to enjoy synergies and share marketing, administrative support functions, a headquarters and so on. Finally, and most importantly, if the tracking stock climbs in value, the parent company can use the tracking stock it owns to make acquisitions.

Still, shareholders need to remember that tracking stocks are class B, meaning they don't grant shareholders the same voting rights as those of the main stock. Each share of tracking stock may have only a half or a quarter of a vote. In rare cases, holders of tracking stock have no vote at all.


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Mergers and Acquisitions: Valuation Matters

Investors in a company that are aiming to take over another one must determine whether the purchase will be beneficial to them. In order to do so, they must ask themselves how much the company being acquired is really worth.

Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.

There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:
Comparative Ratios - The following are two examples of the many comparative metrics on which acquiring companies may base their offers:
Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.
Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop.
Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization - capital expenditures - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.

Synergy: The Premium for Potential Success
For the most part, acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy.

Let's face it, it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy:



In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short.



What to Look For
It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria:
A reasonable purchase price - A premium of, say, 10% above the market price seems within the bounds of level-headedness. A premium of 50%, on the other hand, requires synergy of stellar proportions for the deal to make sense. Stay away from companies that participate in such contests.
Cash transactions - Companies that pay in cash tend to be more careful when calculating bids and valuations come closer to target. When stock is used as the currency for acquisition, discipline can go by the wayside.
Sensible appetite – An acquiring company should be targeting a company that is smaller and in businesses that the acquiring company knows intimately. Synergy is hard to create from companies in disparate business areas. Sadly, companies have a bad habit of biting off more than they can chew in mergers.
Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality.


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Mergers and Acquisitions: Doing The Deal

Start with an Offer
When the CEO and top managers of a company decide that they want to do a merger or acquisition, they start with a tender offer. The process typically begins with the acquiring company carefully and discreetly buying up shares in the target company, or building a position. Once the acquiring company starts to purchase shares in the open market, it is restricted to buying 5% of the total outstanding shares before it must file with the SEC. In the filing, the company must formally declare how many shares it owns and whether it intends to buy the company or keep the shares purely as an investment.

Working with financial advisors and investment bankers, the acquiring company will arrive at an overall price that it's willing to pay for its target in cash, shares or both. The tender offer is then frequently advertised in the business press, stating the offer price and the deadline by which the shareholders in the target company must accept (or reject) it.

The Target's Response
Once the tender offer has been made, the target company can do one of several things:
Accept the Terms of the Offer - If the target firm's top managers and shareholders are happy with the terms of the transaction, they will go ahead with the deal.
Attempt to Negotiate - The tender offer price may not be high enough for the target company's shareholders to accept, or the specific terms of the deal may not be attractive. In a merger, there may be much at stake for the management of the target - their jobs, in particular. If they're not satisfied with the terms laid out in the tender offer, the target's management may try to work out more agreeable terms that let them keep their jobs or, even better, send them off with a nice, big compensation package.

Not surprisingly, highly sought-after target companies that are the object of several bidders will have greater latitude for negotiation. Furthermore, managers have more negotiating power if they can show that they are crucial to the merger's future success.
Execute a Poison Pill or Some Other Hostile Takeover Defense – A poison pill scheme can be triggered by a target company when a hostile suitor acquires a predetermined percentage of company stock. To execute its defense, the target company grants all shareholders - except the acquiring company - options to buy additional stock at a dramatic discount. This dilutes the acquiring company's share and intercepts its control of the company.
Find a White Knight - As an alternative, the target company's management may seek out a friendlier potential acquiring company, or white knight. If a white knight is found, it will offer an equal or higher price for the shares than the hostile bidder.
Mergers and acquisitions can face scrutiny from regulatory bodies. For example, if the two biggest long-distance companies in the U.S., AT&T and Sprint, wanted to merge, the deal would require approval from the Federal Communications Commission (FCC). The FCC would probably regard a merger of the two giants as the creation of a monopoly or, at the very least, a threat to competition in the industry.

Closing the Deal
Finally, once the target company agrees to the tender offer and regulatory requirements are met, the merger deal will be executed by means of some transaction. In a merger in which one company buys another, the acquiring company will pay for the target company's shares with cash, stock or both.

A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash payment for each share purchased. This transaction is treated as a taxable sale of the shares of the target company.



If the transaction is made with stock instead of cash, then it's not taxable. There is simply an exchange of share certificates. The desire to steer clear of the tax man explains why so many M&A deals are carried out as stock-for-stock transactions.

When a company is purchased with stock, new shares from the acquiring company's stock are issued directly to the target company's shareholders, or the new shares are sent to a broker who manages them for target company shareholders. The shareholders of the target company are only taxed when they sell their new shares.

When the deal is closed, investors usually receive a new stock in their portfolios - the acquiring company's expanded stock. Sometimes investors will get new stock identifying a new corporate entity that is created by the M&A deal.


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Should you cheer or weep when a company you own buys another company?

Mergers and Acquisitions: Introduction

By Ben McClure


Mergers and acquisitions (M&A) and corporate restructuring are a big part of the corporate finance world. Every day, Wall Street investment bankers arrange M&A transactions, which bring separate companies together to form larger ones. When they're not creating big companies from smaller ones, corporate finance deals do the reverse and break up companies through spinoffs, carve-outs or tracking stocks.

Not surprisingly, these actions often make the news. Deals can be worth hundreds of millions, or even billions, of dollars. They can dictate the fortunes of the companies involved for years to come. For a CEO, leading an M&A can represent the highlight of a whole career. And it is no wonder we hear about so many of these transactions; they happen all the time. Next time you flip open the newspaper’s business section, odds are good that at least one headline will announce some kind of M&A transaction.

Sure, M&A deals grab headlines, but what does this all mean to investors? To answer this question, this tutorial discusses the forces that drive companies to buy or merge with others, or to split-off or sell parts of their own businesses. Once you know the different ways in which these deals are executed, you'll have a better idea of whether you should cheer or weep when a company you own buys another company - or is bought by one. You will also be aware of the tax consequences for companies and for investors


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Mergers and Acquisitions: Definition

The Main Idea
One plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key principle behind buying a company is to create shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies - at least, that's the reasoning behind M&A.

This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy other companies to create a more competitive, cost-efficient company. The companies will come together hoping to gain a greater market share or to achieve greater efficiency. Because of these potential benefits, target companies will often agree to be purchased when they know they cannot survive alone.

Distinction between Mergers and Acquisitions
Although they are often uttered in the same breath and used as though they were synonymous, the terms merger and acquisition mean slightly different things.

When one company takes over another and clearly established itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer "swallows" the business and the buyer's stock continues to be traded.

In the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forward as a single new company rather than remain separately owned and operated. This kind of action is more precisely referred to as a "merger of equals." Both companies' stocks are surrendered and new company stock is issued in its place. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created.

In practice, however, actual mergers of equals don't happen very often. Usually, one company will buy another and, as part of the deal's terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if it's technically an acquisition. Being bought out often carries negative connotations, therefore, by describing the deal as a merger, deal makers and top managers try to make the takeover more palatable.

A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies. But when the deal is unfriendly - that is, when the target company does not want to be purchased - it is always regarded as an acquisition.

Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company's board of directors, employees and shareholders.

Synergy
Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:
Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also include the former CEO, who typically leaves with a compensation package.
Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies - when placing larger orders, companies have a greater ability to negotiate prices with their suppliers.
Acquiring new technology - To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.
Improved market reach and industry visibility - Companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.

That said, achieving synergy is easier said than done - it is not automatically realized once two companies merge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes a merger does just the opposite. In many cases, one and one add up to less than two.

Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers. Where there is no value to be created, the CEO and investment bankers - who have much to gain from a successful M&A deal - will try to create an image of enhanced value. The market, however, eventually sees through this and penalizes the company by assigning it a discounted share price. We'll talk more about why M&A may fail in a later section of this tutorial.

Varieties of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here are a few types, distinguished by the relationship between the two companies that are merging:
Horizontal merger - Two companies that are in direct competition and share the same product lines and markets.
Vertical merger - A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker.
Market-extension merger - Two companies that sell the same products in different markets.
Product-extension merger - Two companies selling different but related products in the same market.
Conglomeration - Two companies that have no common business areas.

There are two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors:
Purchase Mergers - As the name suggests, this kind of merger occurs when one company purchases another. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable.

Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company.

Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.


Acquisitions
As you can see, an acquisition may be only slightly different from a merger. In fact, it may be different in name only. Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm purchasing another - there is no exchange of stock or consolidation as a new company. Acquisitions are often congenial, and all parties feel satisfied with the deal. Other times, acquisitions are more hostile.

In an acquisition, as in some of the merger deals we discuss above, a company can buy another company with cash, stock or a combination of the two. Another possibility, which is common in smaller deals, is for one company to acquire all the assets of another company. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes merely a shell and will eventually liquidate or enter another area of business.

Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable shares.

Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved.


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Don't Fall For False Security Of 'Defensive' Stocks

In times of uncertainty, and in preparation for market declines,Wall Street’s advice to investors is always the same. The market cannot be timed, and cash does not pay enough interest to even keep up with inflation. So investors need to remain fully invested and continue to buy stocks, but can protect themselves by shifting to ‘defensive’ stocks and sectors.

No matter what happens to the economy people will still have to eat, drink, and take their medicines. So food, beverage, and drug companies will continue to do well in an economic or market downturn, and the stocks of utilities and other solid companies that pay high dividends will also do well since the dividends will help offset a decline in the stock prices.

Although consumers will still have to eat, drink, and take their medicines, investors will not have to continue to value the earnings of those companies as highly as they did in a rising market. Stocks that sell at 20 times earnings in the excitement of a rising market may only sell for 12 times earnings by the time a correction has made investors more fearful. So even though a company’s earnings continue to rise, its stock will still be dragged down by the falling market.

The same holds true for the high dividend payers. They also do not escape the problem of investors not being willing to value their earnings as highly as they did in a rising market.

In fact, since defensive stocks and sectors are touted so heavily by Wall Street near market tops, driving their prices to more over-valued levels than other stocks, their subsequent declines often exceed the decline of the rest of the market.

It doesn’t take much research to check it out, but unfortunately most investors aren’t inclined to bother. However, that is my job, and here are the facts.

Utilities are traditionally among the highest dividend paying stocks, yet the DJ Utilities Average plunged 60% in the 2000-2002 bear market, considerably more than the 50% decline of the S&P 500. And it plunged 48% in the 2007-2009 bear market, not much different than the 50% decline of the S&P 500.

In lesser corrections the degree of safety promised for high dividend paying stocks has been equally disappointing for those who accepted the theory. In the summer correction of 2010 the S&P 500 declined 15%. The DJ Utilities Average declined 13%. So far in the current correction, the S&P 500 is down 7.8%. But the DJ Utilities Average is down 11.6%.  A similar relationship exists between the SPY and XLU ETFs.

Likewise, the ten highest dividend-paying solid companies in the 30-stock Dow are down an average of 18.9% in the current correction, compared to the S&P 500 being down 7.8%.  Look at the DVY ETF and how it has now held up well during the past month.

High-dividend payers have an added incentive for selling in the current correction since one of the risks of the ‘fiscal cliff’ is that taxes on dividends might jump significantly. And that’s true. But those same ten stocks plunged an average of 65.3% in the 2000-2002 bear market, and an average of 55.4% in the 2007-2009 bear, much worse than the Dow and S&P 500.

Meanwhile, we’re seeing the same historical pattern for the ‘still gotta eat, drink, and take their meds’ stocks.

So far in the current pullback, while the S&P 500 is down 7.8%, the still gotta eat and drink category is holding up fairly well, although Coca Cola (KO) is down 10.2% and PepsiCo (PEP) is down 7.3%.

In the ‘still gotta take their meds’ category, while the S&P 500 is down 7.8%, most major drug-makers are down more. Abbott Laboratories (ABT) is down 12.4%, Bristol Myers (BMY) is down 14.8%, Eli Lilly (LLY) is down 14.6%, and Merck (MRK) is down 10.7%.

You can blame it on concerns about drug company profits under Obamacare. But just as the high-dividend paying stocks plunged right along with the rest of the market in the 2000-2002 and 2007-2009 bear markets, so too did the drug-makers. Abbott Labs, Bristol Myers, Eli Lilly, and Merck, plunged an average of 54.5% in the 2000-2002 bear market, and an average of 49.1% in the 2007-2009 bear.

Several conclusions could be drawn from that history. The first is that there seems to be nothing to gain by repositioning into the so-called defensive stocks or sectors. In fact, by doing so one may come out the other side even more damaged than by holding onto current holdings.

Taking profits and moving to cash when risk is high would be a much better strategy, even though the cash would earn nothing, since one keeps the previous profits and can re-enter when the correction ends, rather than having huge losses and needing the next bull market just to get back to even. If the expected correction doesn’t materialize, the cost is only some lost opportunity for more gains, not the actual painful losses incurred by remaining fully invested and moving into so-called defensive stocks.

Another approach, which I prefer, is that the best defense is often a good offense. For instance, an ‘inverse’ etf or mutual fund designed to move opposite to the S&P 500, like the Rydex Inverse S&P 500 fund (RYURX), or the ProShares Short S&P 500 ETF (SH) will gain roughly 20% if the S&P declines 20%, more in larger corrections.

Regardless of what decision is made, let’s be street smart and realize that so-called ‘defensive stocks’ usually are not close to being so.

Sy Harding is president of Asset Management Research Corp.

http://www.forbes.com/sites/greatspeculations/2012/11/20/dont-fall-for-false-security-of-defensive-stocks/?partner=yahootix