How to Make Money on Mergers

"Arbitrage" is a sexy word that means profiting as the middleman while ideally taking little to no risk. But personal investors never get a chance to engage in the standard James-Bond-villain version of it because it now requires such complex systems. But there are two sorts of arbitrage that Joe Anybody can get in on -- time arbitrage and merger arbitrage. Time arbitrage is straightforward, and it's what we do as long-term investors -- making a profit off someone else's impatience. So let's look at merger arbitrage to see whether it's another good way to play in the market.

Looking for a buyout
In merger arbitrage, you make money by purchasing a stock for less than another party is willing to pay to buy that company out. In the standard situation, this can be a difference of nickels. If Joe's Shack is selling at $1.20 but you know that Bill's Conglomerate is going to pay $1.25, then you can buy, hold, and sell for a profit. Often, investors can find these deals right out in the open. Even once an offer is made, there will be a gap in the stock price that reflects the risk that the deal falls through. So where can you find these deals?

Well, nothing screams "profit" like online content, newspapers, magazines, or the Postal Service. Those boys really have it made in the shade. Or at least they did, until the world moved under their feet and the gold walls came tumbling down. Now, these guys are scraping by, if they make it at all, which is why it's a great place to go looking for a buyout. Find yourself a decent name, a low price, and a buyer, and you're on the way to merger arbitrage.

Enter Digital Generation (NAS: DGIT) . The company sells digital and video advertising, and like many of its peers, its profits have been shrinking. Last quarter, revenue grew because of the addition of a number of new services and corporate purchases, but costs grew more. Overall, income before taxes fell 95%, and the company posted a $0.01 loss per share, as opposed to a profit of $0.37 in 2011. That's bad news for Digital, but it could mean good news for investors.

Winter is coming
This is the point where time and merger arbitrage are most clearly divergent. If we were looking for a buy-and-hold opportunity, we'd be running full-speed in the other direction. Even though some analysts have claimed that the company could increase its value by splitting itself up, management has shown no interest in that route yet and hasn't given a clear picture on what it plans to do about the current quagmire. But in merger arbitrage, that's great news.

Digital Generation has apparently already spurned one bidder. In June, it was reported that rival Extreme Reach made an offer of more than $20 per share. That would be more than a 75% premium on today's stock price, and it highlights the risk of merger arbitrage. Sometimes, companies do dumb things, or deals just fall through. Lots of investors got excited when Coty made a bid for Avon (NYS: AVP) earlier this year, only to have the built-up stock crumble when the deal fell apart. The stock is now down 12% on the year, and investors who got in hoping for a deal are left with a loss, hoping for a new suitor.

But when it pays off, both companies can end up stronger, and investors can do very well for themselves. Investors don't need to look much further than the recent Hertz (NYS: HTZ) and Dollar Thrifty (NYS: DTG) deal to see that in action. Hertz expands its fleet, and Dollar Thrifty shareholders get a premium. As evidence of that earlier point, the agreed price was for $87.50, yet the stock is trading at $87.08 as I write this. That buffer represents the little bit of risk and transaction cost that would be incurred to trade the stock.

The bottom line
Another bid for Digital Generation seems likely, especially if the company could increase its value simply by dividing its divisions. A private-equity firm could probably pump that value increase by dumping a lot of the costs and long-term obligations into the weaker division, spinning the stronger division to new heights. But that's all conjecture. I don't like merger arbitrage -- it makes it hard for me to sleep well. There's too much going on that I can't predict, and the strength of a company doesn't always indicate the deal's outcome. That's just not my kind of investing.

But if it were, this would be a fascinating opportunity. The $20 offer in June makes Digital look like a good deal, right now. While it could pay off big time, investors should always make sure that they have a backup plan in case one of their eggs doesn't hatch. To get your hand on three more great investments, check out the Fool's report on Middle-Class Millionaire-Makers. These are three companies that can round out any portfolio, and the report with all the details is free. Get yours now.

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Fool contributorAndrew Marderowns none of the stocks mentioned in this article. The Motley Fool owns shares of Hertz Global Holdings. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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