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How M&A rumors take off

August 22, 2014, 11:00 AM UTC
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This article is part of our Contagion package, a series that explores the science of how things spread.

Leigh Drogen remembers exactly how he first heard that Radware was going to be acquired.

At the time, Drogen was running a hedge fund of momentum stocks, and he’d been watching Radware (RDWR), an Israel-based Internet security firm listed in the U.S. “Everything lined up for me that I should be owning this company, but I hadn’t pulled the trigger yet,” he remembers. Then on Twitter, a respected trader Drogen follows tweeted that a slew of options trades on Radware stock—bets that its shares would rise—had just been made. The trader’s conclusion: The company was definitely a takeover target. “That was the thing that put me over the edge,” says Drogen, who quickly loaded up on Radware shares.

Within a week, Wall Street was abuzz with acquisition rumors: Analysts had labeled Radware an attractive target, and an Israeli newspaper, citing anonymous sources, reported that the company was considering a nearly $1 billion offer from IBM (IBM) or Hewlett-Packard (HPQ). The story was picked up by American blogs and news outlets, sending Radware’s stock through the roof. “It seemed real,” Drogen recalls.

The deal never materialized, but that didn’t matter to Drogen, who was already long gone by the time the dust settled—taking a handsome profit with him. “If one of your stocks goes up 40% in one day on a rumor, you get rid of it,” he says. “You don’t look a gift horse in the mouth.”

It’s a classic example of the power that gossip wields in the market—and the potential rewards for those who play the right rumor before everybody else catches wind of it. The chance to capitalize on such speculation is hard to resist, even for professional investors who swear that they would never trade on anything so flimsy as a rumor (including every portfolio manager Fortune interviewed for this story). It’s their job, after all, to look out for anything that could impact a stock—and mergers and acquisitions, even rumored ones, can sway stock prices more dramatically than most other events.

Sometimes, when M&A speculation catches on, it becomes so contagious it spreads to the market itself, becoming a self-fulfilling prophecy—moving prices as though a deal had just been announced.

In a new Fortune series on Contagion, my colleagues and I set out to explore this phenomenon—from the classically (and fatally) contagious MERS-coV virus (here and here) to more figuratively viral manifestations like stock market selloffs, runaway bestsellers and even the advent of “the selfie.”

With M&A rumors, the contagion effect is obvious, but the mechanics behind it are a complete mystery to many market experts. We know that stock-related rumors are an almost daily part of the trading life. Much less clear is why certain bits of gossip—including some that seem to have little substance at all—catch a wave of trader attention.

“Certainly, rumors move the market,” says Mark Landy, a medical technology stock analyst with Summer Street Research Partners, who has vetted his fair share of M&A gossip. “You have people who invest in the market and people who gamble in the market—and honestly sometimes, the gambling portion of the investment community gives the investment part an opportunity.” There’s even an old investing saying, Landy reminds us: “You buy the rumor and you sell the news.”

Indeed, rumors frequently swirl not because something is going to happen, but rather because people think it will…or should. Investors watch for the same signals of potential deals, analyzing certain financial and economic measures associated with acquisitions, and listening for hints of M&A interest from CEOs and CFOs. Bloomberg terminals—on the desks of most pro investors and traders—keep a running list of “potential global takeover targets” that currently number more than 3,300.

Barrow Street Advisors, an investment firm that has switched its focus from private equity to mutual funds, points out that 60 of its portfolio holdings have been acquired since 2009—a full 6% of the 987 U.S. companies that were actually acquired during the period, which is more than triple the acquisition rate for the market as a whole. “And that’s without going to the rumor mill for ideas,” boasts David Bechtel, a principal at Barrow, saying that his firm looks for companies with the same characteristics that buyout firms would find attractive.

When the right factors are present, though, investors will believe almost any whisper of a deal—and when someone begins trading on that belief, it strengthens the belief of others, who often start trading, too, juicing the stocks and lighting up the options market. “At the end of the day, if there is a rumor, and there is credibility—and there’s action in the stock market that points in the direction of the rumor—that’s something that a lot of people would pay attention to,” says Scott Wallace, a former Alliance Bernstein portfolio manager who recently launched a hedge fund firm in Chicago, Shorepath Capital Management. “What makes a good rumor is a lot of people believe it. And if the stock’s moving on it, then maybe they know something I don’t know.”

A well-kept Wall Street secret, say veteran investors, is that professional traders bounce ideas off each other much more often than their compliance departments would allow. The exchanges are typically behind the scenes, when they run into each other at shareholder meetings, or chat over the phone or in online forums.

“With social media, you don’t have to have friends in high places to see what people are thinking,” Landy says. “And that can be spread wild and fast.” Landy has seen this firsthand—when he speculated in an analyst commentary that a certain company could be a takeover candidate. His gentle musing snowballed into the company being labeled a target all over the web, bumping up the stock’s price.

Of course, problems arise when investors share not a mere hypothesis, but rather confidential intel about a future M&A deal. Acting on such non-public information is known as insider trading, and it’s illegal.

But often, rumors begin to circulate because investors are looking for feedback on a particular M&A theory—or wishful thinkers (say, shareholders and investment bankers) perpetuate them. Or because it’s just fun to make predictions, as Fortune learned when, in our January issue, we took odds on potential mergers between AT&T (T) and Vodafone (VOD), and Amazon (AMZN)and the United States Postal Service.

Take, for example, Howard Lindzon, the founder of StockTwits, the site dedicated to sharing stock ideas in 140-character posts—many of which include potential M&A candidates, he says. “I do it. I’ll speculate on my stream, ‘Wouldn’t it make sense if Twitter bought this company, or that company bought this one?’” Lindzon says. “It’s not insider trading; it’s just sharing an idea. Just to see if somebody else is thinking the same thing.”

In April, Lindzon even dragged venture capitalist Marc Andreessen into the rumor mill, asking him in a Twitter chat, if he were CEO of Apple (AAPL), which companies would he buy? Andreessen took the bait, naming Twitter (TWTR) and Dropbox as good candidates. Meanwhile, myriad followers responded with their own suggestions for deals, such as Microsoft (MSFT) acquiring Dropbox instead. The StockTwits founder, meanwhile, had his own ideas about a Microsoft target: “They will probably buy Box. Feels that way to me based on Levie tweets,” Lindzon chimed in, referring to Box CEO Aaron Levie.

And so the rumor mill churns.

No one knows this better than Drogen, who left the hedge fund world to found a tech startup, Estimize, which allows market watchers to predict financial results for companies. In March, Estimize launched, for people to post their guesses about future M&A deals. Drogen says the idea came from several large hedge funds, who wanted to keep tabs on theories floating around the market.

“They already call each other all the time, but in an official way they could never do that,” Drogen says, adding that major hedge fund analysts and investors are participating on Mergerize, but are using pseudonyms instead of their real names. “That’s why the Street is such a herding mentality, because everybody’s paying attention to what everybody else thinks, because they need to understand when they’re out of consensus.”

So far, one Mergerize member’s prediction has even come true. Anand Thaker, a marketing technology and operations consultant in the Atlanta area, predicted on March 26 that IBM would acquire Atlanta-based marketing startup Silverpop within three months, just two weeks before the deal was announced. Thaker says he closely follows and analyzes companies within the industry, including Silverpop.

His post came a day after an Atlanta business journal reported on the negotiations, citing anonymous sources, but that report did not make national news. The investment news site 24/7 Wall St., which has a section entitled “Rumors,” noted that IBM rose nearly 4% that day, with roughly double its normal trading volume, despite the fact that “the company had no big news” to report. (“There are other such accurate—and inaccurate—predictions, so when Mergerize emerged, I thought I’d post one of those predictions,” Thaker says.)

At least as often, however, M&A rumors lead investors astray when they turn out not to be true. The anonymous messaging app Secret gained notoriety this year when people used it to share false acquisition news. Some investors suspect that companies themselves plant rumors about M&A they’re considering in order to get the market’s feedback, or that investment bankers leak “intel” to pressure companies to close a deal. Drogen, for one, says he has been fielding calls from certain high-profile investor relations departments regarding takeover targets predicted on Mergerize.

“The game of telephone that takes place with these things is crazy,” says Drogen, listing examples: “How many times has RadioShack (RSH) been expected to get taken over for their real estate value? Or that Microsoft is buying BlackBerry (BBRY)? That rumor is always going around and it’s always the bankers who want the deal to happen. It’s basically like, ‘Somebody please bid!’”

Many investors learned this the hard way earlier this summer, when Minneapolis-based medical device maker Medtronic (MDT) announced in mid-June that it would buy its Irish competitor Covidien (COV) for $43 billion. For weeks, analysts from London to New York had been speculating that Medtronic had been shopping in Europe, looking to merge with a company there to secure a lower tax rate, as several other U.S. health care companies had recently done.

For analysts reading between the lines, it was just a matter of who Medtronic would buy. Covidien, though, had never been part of the chain of rumors. By June 4, there were whispers that Medtronic would acquire British artificial joint manufacturer Smith & Nephew (SNN), whose shares rose 12% on the media reports. Landy, the Summer Street analyst, raised his price target for Smith & Nephew, and concedes that he helped perpetuate the theory when reporters called him. “When the Medtronic rumor broke, I said that makes good sense,” Landy says, “because to me, Smith & Nephew was a viable target for Medtronic.”

When the actual target—Covidien—was announced, few rumor-mongers publicly admitted their mistake. Instead, investors and analysts began churning the rumor mill anew, speculating that other industry players, such as Johnson & Johnson (JNJ) and Stryker (SYK), might launch bids of their own.

In the spirit of keeping the gossip going, several investors shared their own takeover theories with Fortune. Drogen agreed with one Mergerize prediction that Apple would buy GoPro (GPRO), and interpreted a Twitter post about heavy options trading on Joy Global (JOY) as a sign that the Milwaukee mining-equipment company might soon be acquired. Shortly after, Joy Global shares surged 8% in a single day. The reason? What else? Acquisition rumors.

Wallace says he’s been watching Broadcom (BRCM), a semiconductor company that is planning to sell off one of its underperforming units: “Once they get rid of that,” he says, “the rest of the business would make for a nice consolidation opportunity for somebody to buy….” Let the speculation begin.


For more inside the world of contagion, see

CONTAGION—How things spread. Introducing a new Fortune series

• Part 1: How a bat virus became a human killer

• Part 2: How the MERS virus made it to Munster, Indiana

• Part 3: How M&A rumors spread

• Part 4: How market selloffs happen

• Part 5: How Americans fell in love with a 685-page economics treatise

• Part 6: How the “selfie” became a social epidemic

• Part 7: How studying Twitter became an academic craze