Trade the Rumor, but Carefully

The rumor mill is running overtime lately, with takeover talk on the upswing in the markets. Most rumors don't lead to signed and sealed deals, and actual transactions aren't much discussed in advance. But mere talk about deals can lead to heavy and potentially profitable option activity, especially as one can attain a large amount of leverage if there is a big jump in a stock's price.

How do we decide if a stock is a rumor play? It isn't only by heavy option trading, although that is often a byproduct of takeover talk. We also look to see whether it shows up on Websites that follow such activity, such as DealReporter or FlyOnTheWall, to name just two.

Some rumors are recurring, such as the one that Radio Shack (ticker: RSH) will be bought out. By our count, such a deal has been rumored 13 times in the past 13 months. Rumors were circulating last week that Genworth Financial (GNW) would receive a takeover offer; similar talk has surfaced at least five times since last October, as has talk that Macy's (M) would get taken out. A buyout of Adobe Systems (ADBE) has been rumored seven times since October, and a takeover of Patriot Coal (PCX), five times in the past year. All have proved to be false rumors to date.

Cephalon (CEPH), on the other hand, received an unsolicited takeover bid from Valeant Pharm (VRX) last week, and the stock jumped 17 points in one day. Cephalon had been the subject of takeover rumors before, and there was some recent unusual call-buying activity in the shares before the deal was announced. But it isn't clear that the option activity was directly related to the forthcoming bid.

OPTION ACTIVITY FIRST INCREASED in Cephalon on March 21, but between that date and the announcement of the actual bid other factors might have led to heavier option activity. The company had announced two small takeovers of its own, and there was a lot of news on a patent-litigation case. Whatever the case, kudos to those who owned the stock or related options before the big move up: That is what all rumor-stock payers are seeking.

Alas, they rarely find it. In the past year, there were 930 separate rumors of buyouts involving 385 stocks. Of that group, there have been 35 actual takeovers, and some weren't preceded by heavy option activity, at least not until the first takeover bid was made. Only 22 deals were rumored in advance, and most of those involved companies that had announced they were "exploring strategic alternatives," which is tantamount to declaring they are for sale.

In such cases, option activity increases, the stock price generally rises and rumors are abundant. Often the takeover occurs at a big premium to the stock's price before the company made its announcement. Shares of Millipore (MML), Gymboree (GYMB) and Massey Energy (MEE) all advanced sharply on the announcement each was seeking "strategic alternatives." The stocks rose sharply again when the companies received takeover bids.

BY OUR COUNT, 44 COMPANIES said in the past year that they were exploring strategic alternatives. (We excluded certain low-priced companies that were unlikely to be able to find buyers.) Sixteen of these companies were taken over at higher prices. Those are much better odds than trying to play market-generated rumors.

It is often the case that a takeover rumor is started by someone who merely wants to sell stock (to you). That is why so many of them are false. But if one concentrates on companies that have hinted they are for sale, and on situations in which a bid has been made, the opportunity to profit improves immensely in what is still a highly speculative and risky way to trade. 

The previous article was published as a column for Barron's The Striking Price on Saturday, April 2, 2011.