By LARRY SWEDROE
Research on the cross-section of stock returns has found that takeovers provide explanatory power. For example, Martijn Cremers, Vinay Nair and Kose John, authors of the 2007 study Takeovers and the Cross-Section of Returns, found that firms with an institutional blockholder (institutional shareholders with more than a 5 percent ownership stake), high book-to-market value, low market capitalisation (small stocks), operating in an industry where a takeover occurred the previous year, higher leverage and lower operating performance have the highest exposure to takeovers. (Note that the takeover characteristic does not correlate strongly with any single input variable.) And since takeovers typically are made with a large premium, firms with high exposure to takeovers have generated large excess returns relative to asset pricing models such as the Fama-French factor models.
Bradley Goldie, author of the 2014 study Takeovers and the Size Effect, examined the role of takeovers on the size and value factors and found that while takeovers had no effect on the value premium, they played a significant role in the size effect, helping to explain the source of the premium.
Sara Easterwood, Jeffry Netter, Bradley Paye and Michael Stegemoller, authors of the March 2022 study Taking Over the Size Effect: Asset Pricing Implications of Merger Activity, examined the impact of takeovers on the size premium by decomposing ex-post average returns for the size factor into a component associated with realized merger and acquisition (M&A) news and a residual. They measured the M&A component of returns using standard event study methods — the M&A component of a stock’s daily return equals the abnormal return on each day the firm is within the defined event window around an acquisition announcement involving the firm, either as target or acquirer. Outside of this window, the M&A component equals zero.
The researchers then computed the daily M&A component of returns for size-based hedge portfolios (and other anomaly long-short portfolios). The acquirer must have purchased 50 percent or more of the target’s shares in the transaction and owned less than 50 percent of the target prior to the transaction. They set the event window to +/-1 trading days for acquirers and to -30/+1 trading days for targets. The authors explained: “The longer window for target firms accommodates the well-known ‘run-up effect’ for targets.” The sample period was 1990-2020 and covered 225,243 transactions. Following is a summary of their findings:
- Sorting on estimated takeover likelihood produced economically meaningful differences in realized takeover activity — realized takeovers involved targets in the high (estimated) takeover probability quintile around 25-35 percent of the time and targets in the low (estimated) takeover probability quintile around 15 percent of the time.
- Takeover targets are more likely to be small firms and therefore predominantly appear within the long leg of the takeover portfolio — 50 percent of takeovers of public firms occurred for firms in the smallest size decile portfolio, and nearly two-thirds of takeovers involved targets in the smallest size quintile portfolio.
- The average annual takeover rate for the small-cap quintile was around 4.5 percent versus 1.9 percent for the large-cap quintile—small-cap quintile firms were 2.4 times more likely to be acquired than large-cap quintile firms.
- The average abnormal target return is positive and economically large. The average target abnormal return was more than 30 percent for the full sample of public firms. However, average abnormal target returns were roughly twice as large for small-cap targets (35 percent) relative to large-cap targets (19 percent).
- Average abnormal returns for small-cap acquirers significantly exceed those for large-cap acquirers, contributing materially to the M&A component of the size premium — although the acquirer average return component was smaller than the target component, it accounted for roughly 20-30 percent of the average total portfolio return.
- The positive average returns associated with size-based hedge portfolios are primarily driven by M&A news — acquisition news explains virtually all of the size premium in U.S. data.
- The smallest decile and quintile portfolios both had average M&A return components of approximately 1.7 percent per year. In contrast, the M&A average return component for the largest decile and quintile portfolios were close to zero.
- An empirical proxy (see Cremers, Nair and John above) for ex-ante takeover exposure positively and robustly relates to cross-sectional expected returns. The annualized CAPM and Fama-French five-factor (beta, size, value, investment and profitability) model takeover factor premium was around 0.8 percent per month (with low turnover, as the portfolio was rebalanced annually) and was much more robust than the size premium.
- The relation between size and expected returns becomes positive or insignificant, rather than negative, conditional on this takeover characteristic—the takeover premium dominates the size premium.
- While the size premium has fallen dramatically since publication in 1981 (The Relationship Between Return and Market Value of Common Stocks), the premium associated with the takeover factor remains robust.
- The takeover model exhibited little explanatory power on most other CAPM anomalies examined (such as value).
- Asset pricing models that include a factor based on the takeover characteristic outperformed similar models that include the conventional size factor.
An interesting finding, especially for investors who have a preference for dividend-paying stocks, was that dividend payers are less likely to be takeover targets.
Their findings led Easterwood, Netter, Paye and Stegemoller to conclude: “Our results indicate that the traditional size factor can be interpreted as an indirect form of the takeover factor, in the sense that the size factor implicitly embeds exposure to underlying state variables that drive time-varying takeover activity. The proposed takeover factor earns a much higher premium than the size factor, especially over recent decades.” They added: “The takeover factor should replace the conventional size factor in benchmark asset pricing models.”
Given the findings of a takeover effect and the fact that small and value companies are both more likely to be acquisition targets, one conclusion you might draw is that if you are going to invest in small stocks, you should invest in small value stocks. That way you earn not only the takeover premium but the value premium as well. It will be interesting to see if fund managers adapt the takeover factor in their fund construction designs.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party data is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Total return includes reinvestment of dividends and capital gains. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-22-280
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
ALSO BY LARRY SWEDROE
CONTENT FOR ADVICE FIRMS
Through our partners at Regis Media, TEBI provides a wide range of high-quality content for financial advice and planning firms. The material is designed to help educate clients and to engage with prospects.
As well as exclusive content, we also offer pre-produced videos, eGuides and articles which explain how investing works and the valuable role that a good financial adviser can play.
© The Evidence-Based Investor MMXXII