Avoid Stocks of Companies that Buy Ailing Firms


It happens all the time. Some big industry consolidation and the healthy company announces it is buying an ailing competitor or even an ailing company outside its traditional line of business. Management of the healthy firm grandly predicts that it will quickly turn the failing company around and make a killing for their shareholders. Superior management, getting rid of workers and excess capacity will certainly increase the profits of the combined company, so the argument goes. In the business pages, some analysts concur and you think, "Hmm this makes sense. Maybe I should buy some shares of the healthy company."

Don't do it.

The strong, acquiring company usually bites off far more than it can chew and often pays too much for the ailing company. The result is that shareholders lose big time.

According to economists Goldman, Sachs & Co. and New York University who studied 38 takeovers in the 1980s, 20 failed, nine were only marginally successful and nine were successful.

By their performance measurements, the "mergers are not successful, although firms that buy other companies in their own industry are more successful than others," they conclude.

They also find that the more an aquiring company pays for the ailing company, the less likely the combined company is to succeed. Healthy firms that borrow a lot of money to finance the acquisition are particularly unlikely to post superior performance. But "the smaller the target is relative to the buyer, the higher is the likelihood of success."

The real issue for investors is the performance of the stock price of the combined company. The answer?

"Shareholders of bidders buying distressed targets fare poorly in the post-merger period." After factoring how volatile the stocks were compared to the market as a whole (beta-adjusted returns), the economists found that the return for the merged companies was -21.9%. Three years out, the return is -26.5 percent.

Lesson? While acquiring companies may, in the long run, increase earnings and their bolster their share prices, don't expect any quick gains.

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