How to look at rumors – the right way
According to research by Yuan Gao and Derek Oler on M&A rumors and pre-announcement trading, in most cases rumors fail to materialize into public announcements. It turns out that short selling rumored acquisition targets is, in fact, a profitable strategy.
The researchers further elaborate that on average, stock prices of rumored firms drift down to their pre-rumor level over a 70-day period after the initial price jump, and that only 12% of rumored takeovers materialize into actual announcements within 70 days. The average return to a shorting rumor strategy over this period is 4.2% (above index), and when one restricts this strategy to only include “hot” M&A years and exclude extremely large mega cap firms, profits increase to 12.7% (again, above index).
In other words, in 88% of the cases, rumors fail to materialize (due to a thousand different reasons), and the investors who were previously rushing to take a piece of the action are now rushing for the exit.
The explanation that the two researchers attribute to this phenomena is very clear–the market always overreacts to takeover rumors. Combining this psycho-financial fact together with the finding that 88% of the rumored takeovers never actually materialize leads to a profitable robust short – selling strategy.
The Foolish conclusion
There’s no need to rush and try and buy shares of a rumored target company. In most cases, you’ll make much more money by shorting the target company right after the rumor has already spread. It turns out that in most cases, well, rumors are nothing more than just rumors.
Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends PepsiCo and SodaStream. The Motley Fool owns shares of PepsiCo, Inc. (NYSE:PEP) and Sodastream International Ltd (NASDAQ:SODA).
The article How To Profit From Acquisition Rumors originally appeared on Fool.com.
Shmulik is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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