BALTIMORE (TheStreet.com) -- The news that Nokia (NOK - Get Report) would buy Alcatel Lucent (ALU) for almost €15.6 billion ($16.6 billion) is making waves, but it's far from out of the ordinary this year. So far in 2015, companies have committed $1.3 trillion to merger and acquisition deals. How much of that have you collected?
Today, we're taking a closer look at what to do with a stock after a merger or acquisition -- regardless of whether you already own it.
Major corporations have a big problem on their hands right now. Actually, they have about $1.33 trillion problems. That's how much cash is collecting dust on the balance sheets of nonfinancial S&P 500 components at last count. Normally, having too much money isn't a bad thing, but when interest rates are near zero, it can be. Investors expect highly paid management teams to earn meaningful returns with their cash -- or else hand it back to the shareholders.
One big solution to that problem has been M&A activity. By buying other businesses, managers get to justify holding on to those record cash reserves. So big M&A deals have been becoming more frequent -- and more lucrative for investors.
That's why we're seeing huge deals such as H.J. Heinz's (HNZ) $55.4 billion offer to buy Kraft Foods Group (KRFT), Mylan's (MYL - Get Report) $31 billion offer for generic pharmaceutical firm Perrigo (PRGO - Get Report) and Pfizer's (PFE - Get Report) $16.8 billion bid for Hospira (HSP). These deals are significant because the targeted companies are so big.
That means there's a much bigger chance that you already own shares of one of them.
2015 is on track to surpass 2007's pre-crash highs for deal volume. But for investors, the important thing is that the premiums are moving higher, too. The average premium is 21.3% this year, a rise from the 17.6% on average that investors got paid last year.
So if you own a stock of a corporation that's being acquired, what should you do?
There are a couple of things to consider when you own a stock of a company that's being purchased. First, there's the question, Should you sell your shares now or hold on?
Newly announced deals almost never result in a company's being immediately traded for the offer price because the market factors in a risk discount (measuring the chances the deal won't be consummated) and a time discount (a premium that buyers get to collect in exchange for giving you an out now).
Both of those prices are fluid; they're determined by supply and demand for shares in the market. This is why, as of Wednesday afternoon, Alcatel Lucent shares trade for about $4, a 25-cent-per-share discount to the current value of Nokia's offer. That's just slightly more than a 6% discount.
These discounts are typically tied to overall volatility in the market and to interest rates. In other words, when market participants are figuring out whether they should buy your ALU shares today, they're weighing the risks as well as how much money they would be able to make elsewhere.
The thing is, the market in 2015 has been underweighing volatility. Even though the big market indices are basically flat this year, the market averages have gotten there by sawing back and forth -- and almost 40% of S&P 500 components are either up or down by more than 10% year-to-date. In other words, there's volatility there, but it's not being fully priced in.
In this sort of environment, it makes sense to sell your shares of the M&A target and walk away with the gains. By doing so, you're effectively giving buyers a 6% fee to take all your risk off the table between now and the ALU merger's expected completion date next summer. A lot can happen between now and then.
Don't forget that if a stock of a company you own is acquired for cash, it may be months from the time the old stock stops trading until the cash shows up in your brokerage account. At some point, it's a better deal to take the money and run.
What to Do When You Don't Own Shares
What about the other side of the deal? Does it ever make sense to buy shares of an M&A target that's already been announced?
The short answer is yes -- but you must be opportunistic. After all, the discounts on merger deals exist for a reason. For Alcatel, the 6% premium available Wednesday afternoon reflects the risks of buying it.
Look at a deal full of regulatory hurdles, such as the proposed Comcast (CMCSA - Get Report) acquisition of Time Warner Cable (TWC), and the risk premium jumps as high as 8%. You won't get to collect an 8% premium on the deal because other market participants are stupid. Rather, the premium is there because TWC shareholders wanted to secure their risk-free gains.
Taking advantage of premiums in M&A deals is called "merger arbitrage." And while there are arbitrage opportunities that make sense for retail investors to take advantage of, they require some legwork to find. As the time between now and a deal's close shrinks, so does the premium you will be able to collect. Remember, you're getting paid to take risk away from the folks who own the stock of the targeted company.
One final thought: The most successful merger arbitrageurs stay market neutral. They buy the target stock and short the acquirer so that they're only exposed to the premium. Otherwise, a good deal can lose money in a down market.
Buying M&A stocks after announcements isn't a strategy for beginners. But as premiums continue to rise in 2015, it should keep becoming more lucrative.
On the other hand, there's nothing quite as exciting as already owning a stock when an acquisition announcement hits. That said, when interest rates are low and volatility is cheap, it almost never makes sense to hold on to your shares until the deal closes.
The next time an M&A deal hits your portfolio, take the money and run.