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You Can Still Make Money With Merger Arbitrage

Two deals in particular look very tempting.  
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Despite a rather prosperous and confident market, one slice of the investment landscape that is typically non-existent is surprisingly showing signs of intrigue. I'm referring to the price gap between pending merger and acquisition deals.

In a very simplified fashion, it goes like this: Company B agrees to merge or be acquired by Company A for $25 per share. Prior to the deal announcement, shares in B were trading for $20. They now trade for $25, or within pennies of that price, because if they didn't, investors would buy shares in Company B knowing that in a manner of months, they will get $25 per share, essentially capturing a risk free profit -- a process known as merger arbitrage.

Back before market information was measured in split seconds, merger arb was a decent area for nearly risk-free investment gains. Often, the biggest opportunities arose when there was perceived risk in a deal actually closing, creating an opportunity for astute investors to cash in. That being said, there are instances when the likelihood of a deal closing poses legitimate risk, and in that case taking advantage of the gap in price is no trade at all.

Today, however, there are a few interesting deals pending that appear to have a good chance of crossing the finish line, although the market is not yet convinced. Consider Office Depot (ODP), which agreed to be acquired by Staples (SPLS) earlier this year. Staples offered $7.25 in cash plus a fifth of a Staples share, worth $2.50 today, for each share of ODP. Office Depot shares trade for $6.88, versus the offer price of about $9.75, a gap in excess of 30%.

The market is concerned that the FTC will block the deal on anti-trust issues. Recall that Office Depot acquired Office Max, so if Staples acquires Office Depot, it will effectively become the only standalone office supply store. The FTC is set to make a ruling later this year. Were this deal to consummate within six months, the annualized return would be in excess of 60%.

Healthcare giant Anthem (ANTM) has a pending deal to acquire Cigna (CI) for $48 billion in cash and stock, not including debt. Cigna's market cap today is $34 billion, a significant discount in an industry that has seen a wave of consolidation.

Mr. Market is not a dumb fellow, but he can be and has been irrational. As these deals take longer to close, his impatience kicks in and he starts to lose interest. The jury is still out as to whether these two mergers will happen, but they provide an excellent idea source for investors looking for a significant return during a fixed period of time, with perhaps little risk.

At the time of publication, Sham Gad had no positions in the stocks mentioned.