As an investor, you put time and effort into carefully selecting the best investments for your portfolio, working with your wealth advisor on striking the right balance of risk and avoiding being too concentrated in one sector.
So what happens when business conditions change the playing field? What should you consider when one of your equity holdings announces it is either making an acquisition or being acquired by another company?
Stuart Freeman, Co-Head of Global Equity Strategy with Wells Fargo Investment Institute, says this is an important time for you to think carefully about how to proceed.
Do your research
When an acquisition is announced, there are two things to note right away.
- Is your holding being acquired or doing the acquiring? Even if a deal is announced as a "merger," there's still a buyer and a seller. If you hold stock in the company making the purchase, your holdings are unlikely to change — although the company may be in a different strategic position than it was before the purchase. If your investment is in the company being sold, you should receive documentation about what the deal means for your shares.
- What are the terms of the purchase? Companies typically make purchases using stock, a combination of stock and cash, or, in rare instances, cash only. The terms of the purchase will determine how your shares are treated. You'll probably receive a certain number of shares of the buying entity for every share of equity you own in the company that's being sold.
Understand the long-term change
You may notice an increase in the value of your holdings when the deal is announced. "A stock can go up pretty dramatically when a merger or acquisition is announced," Freeman notes. But that shouldn't necessarily drive your long-term decision on what the deal means to you.
"The key really is if you like the company that you have, and you think the buyer is someone who is well-managed and has a history of melding companies together well," Freeman says. But in some ways, the analysis is "starting all over from scratch" if you're unfamiliar with the purchasing company.
Consider the impact of cashing out
The factors to consider when deciding whether to hold the stock or sell are similar to the ones you would think about when making a new investment. How aggressive is the new company compared with the old? Are they a big conglomerate that operates in numerous sectors rather than just one? Did they have to take on debt to make the purchase? Do they pay a regular dividend? If you aren't comfortable with the answers to these questions, or to how the new holding will fit in your portfolio, you may want to consider selling your shares.
Freeman notes that selling carries a potential tax impact, as you may be subject to capital gains taxes on any profit you've made from the investment. If you hold your shares, the transaction is a transfer of shares as opposed to a sale, so capital gains taxes wouldn't apply until you do decide to sell.
Are more mergers and acquisitions on the way?
Freeman notes that while there hasn't been a merger and acquisition (M&A) frenzy in the market (the number of M&A deals in the U.S. was down 10% from the previous year for the 12-month period ending Oct. 31, 2017, according to FactSet, M&As do tend to increase as the economy approaches the later stages of the business cycle.
"Quality companies may have their stock priced at a pretty attractive level to be able to use their stock as their purchasing vehicle," Freeman says.
While M&A activity may have a positive impact on the stock price of the companies involved, Freeman notes it's probably not a sound strategy to seek to invest only in companies that could be bought out.
"That's a little like trying to catch lightning in a bottle," he says. "And you still need to be sure you're buying a company with good fundamentals that's attractively priced. You don't want to get stuck with a company that never gets bought and was never really that great a company to begin with."