Investors know most mergers don't make sense but are willing to bet that some do

Serious Money: Mergers and acquisitions (M&As) are hitting the headlines on a daily basis, setting up all sorts of interesting questions for investors, not least of which is how to spot where the next deal is coming from. Market insiders are muttering "it's 1999 again", meaning that merger mania is back to its most recent peak.

And that is amazing: 1999 saw the dotcom madness take deal activity to unprecedented levels. What followed was not just a stock market bust, but an outpouring of research that conclusively proved that most M&A deals destroy rather than create shareholder value.

One of the reasons why stock markets are so strong, despite soaring energy costs and concerns about the growth outlook, is that investors are once again welcoming M&A deals, a sharp reversal of attitudes prevalent for the last five years. What is going on?

The list of companies involved in deals is long. Most recently, the German utility E.On is reported to be thinking about bidding for Scottish Power and another German company, Deutsche Post, is attempting to buy UK logistics company Excel. The combined value of these deals is likely to be near €25 billion.

Again in Germany, insurance giant Allianz announced that it was issuing more shares to fund the near €6 billion purchase of Riunione Adriatica.

Further afield, this week saw Oracle buy Siebel Systems for $10.66 (€8.68) a share - a near 30 per cent premium for anyone fortunate to have bought into the stock a couple of weeks ago.

In a private deal, Ebay bought internet phone company Skype, the latest in a series of moves by tech companies trying to position themselves so they can do to traditional phone companies what Microsoft did to Netscape (destroy them).

Again in the US, troubled Ford Motor is rumoured to be thinking of selling car rental company Hertz for $15 billion.

One of the more peculiar features of recent deal announcements is the alacrity with which they have been greeted by investors. Because of all that evidence suggesting that companies doing the buying often mess things up, it might be thought that the share prices of firms that bid for other businesses will always see their share prices fall.

Surprisingly, in a lot of cases, the reverse has happened. So it benefits investors to be involved in those stumping up the cash as well as in target companies.

Pernod Ricard, for example, saw its share price go up following its move to buy the UK drinks giant Allied Domecq. Italian bank UniCredito also saw something similar happen when it bid for German bank HVB. Does this trend suggest that investors have forgotten the lessons of the past?

Not all deals are value destroying, just most of them. For the current phase of deal fervour to make any sense, we have to argue that something is different this time - and that kind of argument should be used with great care, as it is was the most common justification for the bubble itself. But deal appetite tells us a few interesting things.

First, and most obviously, deals make more sense when equities are generally cheap - or, at least, not expensive - and companies on both sides of the Atlantic are flush with cash. It also helps if borrowing costs are low. All of these conditions hold at the moment.

The evidence that previous deals generally didn't make money may be biased because companies bought each other at a time when valuations were much higher than they are now.

It is also true that risk appetite is quite high. This means that investors are fully aware that most mergers don't make sense but are willing to bet that some do. Because it takes time to find out which deals make money, it is logical for the punter to bet on all of them in the hope that the gains, where they occur, will be of sufficient size to outweigh the losses. Time will tell.

So where will the next deals occur? Which companies should we buy in the hope that somebody else will come along and pay a nice fat premium to gain control? Sadly, this is one of the toughest calls to make. It's not as simple as identifying, say, undervalued companies with poor management that could be transformed by new owners (although that is where the search usually starts).

Mergers often take place for strategic reasons, rather than on purely financial criteria. Sometimes egos play a much bigger role than they should.

Lists of potential deal makers have to include telecommunication companies.

The competitive pressures that these companies face sit very uncomfortably alongside very limited growth opportunities, but these businesses are as cheap as they have been for some time and are throwing off large amounts of cash, and the market seems willing to ignore the fact that they still typically carry a lot of debt on their balance sheets.

Other candidates include European banks, particularly small to mid-size operations.

German companies of all kinds offer potential, given the extent to which foreigners, particularly hedge funds, now play in that market. Utilities have been buying each other and this could well continue. Oil and other energy-related companies are also good suspects.

M&A will continue at high levels. Those of us without a crystal ball can be comforted by the knowledge that deal activity should help to keep the overall market buoyant.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.