Investing: Managing Your Trade with Stop

The Question

In early April, a friend of mine called. My friend, who we’ll call Sally, was concerned that Huntsman, a stock I had recommended in a previous article, had dropped. She told me she had purchased 200 shares of Huntsman at $23.81. Yet by early April, the stock was dropping. On April 3, it had fallen to $22.71. By April 9, the stock was at $22.11. Here’s a recent chart of the stock:

The Background

Now, a few more details to give you context. Late last year I had written about Huntsman, highlighting it as a merger arbitrage opportunity. Merger arbitrage refers to the difference between a stock’s current price and the acquisition price. Often this spread widens prior to a merger’s closing, creating a profit opportunity for investors.

In Huntsman’s case, the stock had been trading in the $19-20 range before the merger announcement. In July 2007, Hexion, another chemical company, agreed to acquire Huntsman for $28 a share. In the days following the merger announcement, the stock jumped to as much as $28.07. Then, over the next month, the stock declined, falling as low as $24.08 in August 2007. Take a look at this chart of the stock over the last two years:

Why did the stock drop to $24 a month after the merger announceme? In theory, an investor could buy the stock at $24 and pocket a $4 gain when Huntsman is acquired for $28. But sometimes, mergers take a long time to complete. And some investors would rather put their money somewhere else in the meantime. Usually mergers take at least six months to close, and because this was a chemical company buying another chemical company, the transaction would have to clear antitrust hurdles. Meaning, the transaction could take a year or more. It’s already been eleven months since the merger announcement, so we’re not wrong there.

So if you were a previous owner of Huntsman stock, you have a big incentive to sell the stock right after the merger announcement. Let’s say you had bought the stock at $20. After the merger announcement, you could sell your shares for anywhere from $24-28, take a $4-8 profit, and go home. If you have another stock that you are just dying to buy, you go ahead and do that.

Meanwhile, if you believe the transaction will close, you can buy the stock at $24 and earn $4 when the deal is completed at $28. If it takes a year, that’s 16.7% annual return. That’s the merger arbitrage opportunity.

But, I did say “if you believe the transaction will close.” Last summer, given the subprime slime aka the credit crunch, many questioned whether many announced transactions would close. In my previous article, I argued that if you were going to try to play this game, you should look for deals with the following characteristics:

Strategic merger

In cases where the merger is a strategic acquisition, the merger is more likely to close. Huntsman fits this criteria; it’s being bought by a Hexion, another chemical company. The merger makes the combined entity a stronger player in the chemicals market. Now, if Huntsman were being bought by, say a hedge fund, the transaction is less likely to close when credit markets are tight. The financial buyer is doing it because he expects a good return, and a change in financing conditions could easily reduce that expected return. Last year, as the credit markets turned, several transactions were canceled.

A cash deal

In a cash deal (which can include debt), the final closing price is predictable. In a deal that includes stock, the final price will change as the stock prices of the individual companies changes. Recently, Microsoft offered to buy Yahoo for $31 a share. However, this transaction included stock, so as Microsoft’s stock price fell, so did the Yahoo acquisition price. Currently, Microsoft would be buying Yahoo for $29 or so, not for $31. As of this writing, Hexion is still expected to buy Huntsman for $28.

No major issues in the seller’s fundamentals

As these transactions evolve, it’s always good to make sure that the seller’s economics don’t take a turn for the worse. Last year, Sallie Mae was to be acquired by J.C. Flowers, a hedge fund. A change in student loan legislation that would cut government subsidies to Sallie Mae changed the company’s economics. J.C. Flowers backed out of the deal, and the change in fundamentals was at least part of the reason. To date, I haven’t found substantial changes in Huntsman’s business prospects.

So I argued that Huntsman was a good merger arbitrage opportunity. The Huntsman transaction fit all of these criteria. Plus, it had three added bonuses. First, management was buying substantial shares of the company. In August 2007, Jon Huntsman Sr., the Chairman, and his eldest son Peter (currently CEO, President and Director), purchased 637,700 shares for $15.4 million at prices from $23.25 to $24.50. Then in late November 2007, Jon Huntsman bought another 25,000 shares for $23.85, and Peter Huntsman bought 20,000 shares for $24.41 to $24.45 each.

Secondly, Hexion agreed to pay interest on the acquisition at a rate of 8% per annum if the transaction did not close by April 5, 2008. Given we are past that date, Hexion is now in that window.

Third, Hexion had already invested $100 million into the deal. Prior to Hexion’s offer, Basell, another chemicals company, had agreed to buy Huntsman for $25.50. Hexion made the higher offer of $28.00 per share, and Basell didn’t counter, so Hexion emerged as the winner. Still, canceling the Basell deal required a $200 million breakup fee, half of which was paid by Hexion. Given Hexion’s investment, it’s somewhat less likely that the company will pull out of the deal.

The Current Situation

So why did Huntsman stock start to fall in early April 2008? You’ll notice that early April is when Hexion would have to begin paying 8% interest on the acquisition. Investors realized that the transaction would not close by April 5, 2008, the first target closing date. Now Huntsman had already reported on January 26, 2008 that the transaction would be extended 90 days beyond April 5, 2008 to July 4, 2008. Still, I think investors were hoping that the transaction would close by April 5th. So when April rolled around and there was no news, investors sold off the stock. Now, that could mean investors lost confidence in the deal, or that they just wanted to park their money somewhere else while they waiting for the deal to close.

I think it’s the latter, that investors are putting their money somewhere else because nothing was going to happen for a little while. Why do I think so?

First, credit markets have actually gotten better, I believe. As I wrote in last month’s article (“Investing: The Line in Sand”), the Fed’s rescue of Bear Stearns drew a line in the sand and eased concerns that there might be a run on financial institutions. If you agree with that, then you have to believe that credit conditions have improved, and that reduces the risks of credit problems derailing the Huntsman acquisition. I think the market agrees; today, the market closed with the Dow above 13,000 for the first time in months. I’m not saying that the credit problems are over; they’re just better than before the Bear Stearns debacle.

Secondly, management continues to buy shares. In mid-March, Huntsman CEO Peter Huntsman bought another 20,000 shares for $23.50 to $23.80 each. In late February, Huntsman CFO bought 5,000 shares for $23.97 to $24.00 a share.

And just so you know, I’m long on the stock, and bought another 200 shares today, May 1, at $23.01. So I think the probability of a close at $28 is still very high.

The Next Step

So what’s the next step? And what does this all mean for my friend Sally?

I believe the major remaining risk is regulatory. Hexion and Huntsman have overlapping businesses, and when they put the transaction together, they anticipated a longer than usual review period with the FTC. Regulators may slow the transaction, but I’m inclined to believe that Hexion and Huntsman would rather sell any assets that are a problem rather than allow the deal to be squelched by regulators.

In previous announcements, Huntsman has said that a transaction will not occur before May 3rd, and the company is scheduled to report earnings on Friday, May 9th. Sometime in the next two weeks, Huntsman will have to give some indication of the transactions’ status. If the indication is positive, meaning that the deal is on track and is likely to close soon, then the stock price will hold or rise. If there are extensions or additional problems, the stock is likely to fall. An extension will cause some investors to step out and perhaps come back at a later date. If the problems are more serious, the stock is likely to fall to pre-transaction levels ($17-20), or somewhat lower because the economy is now weaker.

In other words, there’s some potential for volatility, and this is a trade that may require some managing. For me, I’ve spent some time thinking about the volatility, and am ready, as much as I can be, to accept it. I also know that I’m dealing with probabilities and not absolutes. So there’s a risk that I’m wrong about all this and that the stock will drop. If that happens, I won’t be happy, but I realize its part of what I signed up for.

Unfortunately, I can’t say the same is true for my friend Sally. When she called, she told me it was her first stock investment, and that it was her mother’s savings. Okay, now I’m feeling some responsibility for all this.

Truth be told, I’m not sure I would have recommended Huntsman for a first investment for my friend Sally. Not because it’s a bad idea by any means; it just has more volatility than, say, Altria or PMI (Philip Morris International), which I have been recommending. The other issue is that the Huntsman deal has a time limit. That time limit will force the stock to go one way or the other. So the Huntsman deal is relatively riskier. In contrast, holding Altria or PMI has no time limit; if it doesn’t do as well as expected this year, it could do so next year, or the year after. In other words, I would say that these are different investments for different risk profiles. So something like Altria or MO might be more suited for my friend Sally’s risk profile.

That being said, it doesn’t help her much now that she is in the stock. What can she do now to limit her downside? The simplest thing is to put a stop on her holdings. A stop order, also known as a stop-loss order, tells the broker to sell if the stock hits a specified price. With most online brokerages, this order can be executed electronically.

Sally purchased Huntsman at $23.81. Today, the stock is at $23.01. She could put in a stop order for, say $22.50. That would limit her loss to $1.31 per share. With 200 shares, that would be a $262 maximum loss.

The disadvantage of a stop order is that it will force an exit on a temporary dip to that price. So let’s say the stock falls to $22.50 on a certain day, but comes back to $23.00 a day later. The stop will have been executed at $22.50, and so the $262 loss is locked in.

The other potential issue is that there is no guarantee that the stop order will be executed exactly at the given price. If the market is moving too fast, the stop might be executed at less than $22.50 because the broker can’t execute the trade fast enough.

I suspect that as we get close to a company announcement about the status of the deal, the stock will creep back up. Yesterday, Huntsman was at $22 or so. I was thinking of buying and today, mid-day, it crept up to $22.50. As I was filling out the buy order on my computer, the stock hit $23.00. So already it’s moving a bit. For my friend Sally, she could put in a stop at $22.50. If the price continues to increase, she can cancel or reset the stop higher, following the stock up. This will decrease the maximum loss as the stock rises.

The other way to limit downside is to use options, but I think this is a bit complicated for a novice investor. In addition, most brokerage accounts require you to apply for options trading, and so it takes a few days to process and set up your account so that you can trade options.

So I’m not recommending this for new investors, but I’ll run through it just so that the idea has been introduced.

Today, my friend Sally could buy a $22.50 put that expires May 16, 2008, for $0.94 (that’s already a mouthful, isn’t it?). The put gives you the right, until May 16, to sell the stock at $22.50. Usually, these puts are sold in lots of 100, and so it would cost $188 to buy puts for her 200 shares of Huntsman.

In this case, the stop order is a better idea. If the stock drops to less than $22.50, Sally will have lost $23.81 – $22.50, or $1.31 per share, plus the $0.94 per share cost of the put protection. That’s $2.25 per share, or a $450 loss if the stock drops below $22.50. And keep in mind that this option expires on May 16, so there’s no protection beyond that point. With a stop order, it can be renewed indefinitely, and in this case, it costs less. The only advantage is that you don’t have to execute the put if you don’t want to.

In another situation, or at another price point, the put may be the better choice, but for now, a simple stop order is probably the best way for my friend Sally to manage the downside. If it helps some of you sleep better, than I’ve done my job. Until the next time.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.