Street Smart
Research alert
Research alert
By David Geracioti
Page 40
(c) 1998 SmartMoney. All rights reserved.

At the Apr. 6 press conference announcing the Citicorp-Travelers Group merger, attendees were worked into such a frenzy that it felt more like a rock concert than a Wall Street announcement.

But investors would be wise to cast a skeptical eye on such highly touted deals. According to a Journal of Financial Economics study to be published in August, stocks of companies that were involved in mergers and acquisitions trail their peers by an average of 4 percent three years after the deal is completed. That underperformance is even worse if you look specifically at companies that the study defines as overvalued and that execute their deals by a merger (in which bidders tend to pay for another company with stock), say the authors, Raghavendra Rau of Purdue University and Theo Vermaelen of Insead, a business school in France.

The professors examined more than 3,000 mergers and nearly 350 tender offers (in which companies usually pay with cash) that took place from 1980 to 1991. The stock of overvalued firms that used mergers to come together underperformed the stock of similar firms that did not participate in a merger by a whopping 17 percent. (The professors used book-value/market-capitalization multiples or net assets divided by market cap to find overvalued companies. The lower the multiple, the pricier a stock.) Interestingly, overvalued firms that use tender offers to make an acquisition do not underperform -- but neither do they outperform.

On the other hand, the authors found that out-of-favor companies that bought competitors via a tender offer did 15.5 percent better than the average company of a similar size and book/market-cap ratio three years later. Even value companies that merged outperformed their peers by 7.6 percent.

Why do value firms outperform more fast-growing companies? "Hubris," says Rau. "With growth companies, managers are more likely to overestimate their own abilities to manage an acquisition."

Value managers, he maintains, are more prudent.

What's an investor to do? Instead of chasing the latest deal, you may want to consider putting money into an industry that is consolidating in general, such as banking, telecommunications or media. M&A fever can rally an entire sector, whether or not your company gets bought or sold.