Intelligent Design

John McMillen | Portfolio Manager

Learn what matters - and what doesn't - when building a sound investment strategy.

What Does Bank of America's Acquisition of Merrill Lynch Tell Us About Stock Picking?

March 2009

The investment industry is full of individuals who claim to have the ability to make great stock picks (i.e., accurately assess mispricings in stock valuations and beat the market). Irrefutable evidence, however, shows that this is rarely accomplished, and when it is accomplished it cannot be attributed to skill anymore than luck.

It is therefore troubling that everyone from small retail investors to large institutional investors still widely embrace this hallmark of any active strategy. Virtually every portfolio we analyze for prospective clients holds some (in most cases many) individual stocks.

It sounds enticing when investment professionals try to sell us on their ability to pick winning stocks and beat the market, but such a strategy is extremely difficult in practice. I thought it might be helpful to demonstrate the futility of this strategy by highlighting the recent acquisition by Bank of America of Merrill Lynch.

In theory, such an acquisition is similar to stock picking: You identify your acquisition target via a screening process, scrub the financials, run it through a valuation model, compare it to the market price and make a decision.

In September 2008, Merrill Lynch’s balance sheet was so impaired from its bets on subprime mortgages that it appeared poised to suffer the same fate as Lehman Brothers – bankruptcy. Enter Bank of America, which sensed a “fantastic” opportunity (their words, not ours) to acquire one of the largest brokerage and investment banking companies in the world. The deal was set to close at year-end.

Even though the market was indicating its opinion that Merrill was worth far less than the purchase price Bank of America had agreed to, BoA proceeded ahead. As the deal prepared to close on December 31, 2008, hundreds of investment professionals from several leading investment banks and consulting firms spent thousands of combined man-hours poring through Merrill Lynch’s books. Ultimately, they valued the company at $29 per share, or $50 billion dollars. This was a significant premium to the market’s assessment of Merrill’s stock, which by that time was trading at $17. Both parties repeatedly assured investors their due diligence was solid. The deal closed on Jan. 1, 2009.

Prior to the announcement of the Merrill acquisition in September, Bank of America stock was valued above $30 per share. By mid-February, after the deal had been finalized, Bank of America reached a low of about $3 a share, down more than 90%. It was no coincidence that, by February, Bank of America stock was trading as though it had blown $50 billion of its shareholder’s equity. Obviously, the market did not agree with BoA’s $29 per share valuation of Merrill and took it, unmercifully, from its new owners for their error in judgment.

This should be a stark lesson to anyone who thinks they know more than the aggregate view of the market. If hundreds of well-educated, smart and well-trained individuals with unfettered access to critical information cannot come even reasonably close to a correct value for one of the most well-known firms in the world, we have to wonder why your average active manager should be able to find “hidden” values in such an efficient market.

As the data shows – and as Bank of America can attest – the pricing efficiency of the market is not a force to be trifled with.

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