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Why Broken-Off Mergers Can Be Big Wins for Investors

March 13, 2017, 11:30 AM UTC

February may be a month that celebrates love. But this year it was a month when unrequited feelings and disapproving authority figures doomed at least two would-be power couples.

First, insurers Aetna (AET) and Humana (HUM) abandoned their $37 billion merger after a federal judge sided with Justice Department antitrust regulators and blocked it. Just a few days later, consumer goods giant Unilever (UL) rejected Kraft Heinz’s $143 billion acquisition offer. All four stocks plunged on the news (Kraft and Unilever shares were still depressed weeks later).

Those failed hookups were the latest in a recent string of missed connections among would-be conglomerators and acquirers. (Drugmakers Pfizer and Allergan, insurer Anbang and hotelier Starwood, and a host of energy companies led 2016’s list of star-crossed lovers.) Their shareholders could be forgiven for gloomy reactions. The idea of a merger or ambitious, synergy-promising acquisition is often intoxicating: The combined company can boost profits by pooling resources and axing redundant costs and personnel. In practice, though, the optimism of a corporate wedding often fades as real life intrudes. Fusing corporate cultures can lead to slowdowns, conflicts, and confusion; debts and other costs related to the acquisition become a drag on earnings.

The upshot: Post-merger stocks often underperform. The profit margins, earnings growth, and return on capital of merged companies all fall behind those of their industry peers in the three years following a deal, according to a 2016 study of Russell 3000 companies by S&P Global Market Intelligence. And a recent working paper by UC-Berkeley researchers shows that the stock returns of merged companies three years following the deal are on average 24% lower than returns for rival acquirers that competed for the same targets but lost.

That means that a broken-off merger can be a dodged bullet, says Todd Ahlsten, who oversees $16.5 billion as chief investment officer at Parnassus Investments. Think of a company in merger talks as a house that’s on the market, says Ahlsten. Interested buyers discuss upsides (the wonderful school district) and downsides (the horrible plumbing). Similarly, a deal discussion is a kind of company audit, forcing both acquirer and target to take a hard look at their own performance. “You hear what buyers like or don’t like, and you learn what things are value creating and what are not,” he says. The result, says Christian Correa, who comanages the Franklin Mutual Beacon Fund, is that deal breakups often create opportunities to buy shares of a strong company at a low price—­especially since the target’s stock often falls. “We get excited,” he says.

It’s hard to find a truly undervalued stock these days, after several months of the Trump Bump rally, but asset managers and stock pickers are still spotting relative bargains. We consulted several pros for their takes on companies that have been involved in broken or thwarted mergers since early 2016 to see which ones could rebound the furthest from their failed romances.

One company that some investors consider better off without its suitor is ­Unilever. As Fortune wrote in its March 1 issue, the company has faced pressure to deliver better returns from its socially responsible business model. The rejected Kraft (KHC) offer could be a catalyst that prods it to do just that. Unilever rejected a deal that placed an 18% premium on its stock price. To keep investors happy, Unilever’s management will have to prove it made the right decision by beating that premium.

Stephen Yacktman, who manages over $16 billion as chief investment officer of Yacktman Asset Management, increased his stake in Unilever at the end of 2016. The company has a lot of potential to grow sales thanks to its international presence, Yacktman says. Moreover, it has fat to trim in the form of layoffs and advertising budget cuts—and those reductions will have a bigger impact for shareholders than they would if Unilever were folded inside a giant like Kraft. Kraft’s operating profit margins were an enviable 23% in 2016. Unilever’s margins were 15%—a sign of how much improvement is possible, says Peter Langerman, comanager of the Franklin Mutual Shares Fund.

Another recent target that may be stronger single: aerospace and defense giant United Technologies (UTX). The company explored a $90.7 billion acquisition offer last year from competitor Honeywell (HON)—at a 22% premium to UTC’s stock—only to call it off in February 2016 because the firms feared they wouldn’t clear antitrust review. Shares of UTC jumped on the offer news, but after the deal was scuttled, they kept rising; they’ve gone up about 20% since then. Investors may have seen the merger offer as a vote of confidence: “If Honeywell thinks it’s a good buy, it helps validate our position,” says Robert Zagunis, a managing director at Jensen Investment Management.

In UTC’s case, responding to antitrust scrutiny might have weakened the company. It “would have been forced to divest really great assets,” says Scott Glover, director of equity research at USAA—most likely parts of its aerospace business, which accounts for 25% of sales. Indeed, that’s the business that makes UTC attractive as a stand-alone. By 2035 the world’s airplane fleet is expected to more than double, and UTC is positioned to capitalize on its relationships with Boeing, Airbus, and the federal government. Zagunis particularly likes the company’s Pratt & Whitney PurePower Geared Turbofan, a quieter and more fuel-efficient aircraft engine.

Pfizer and Allergan announced a $160 billion merger in November 2015; they scrapped it last April after controversy erupted over the tax benefits of the merger (which would have enabled Pfizer to move its headquarters from the U.S. to low-tax Ireland). Allergan’s shares are down 22% since the deal was announced and haven’t moved since the breakup. But Parnassus’s Ahlsten expects the stock to recover, partly thanks to Botox, which Allergan produces. He is betting on the injection’s seemingly endless potential treatment applications, ranging from erectile dysfunction to depression. Allergan’s price-to-2017-earnings ratio of 14, measured against the S&P 500’s 18, makes a bet on a Botox bounce look alluringly cheap. 

The High Cost of a Corporate Marriage

-5.3%: Amount by which profit margins of merged companies trail those of their industry peers three years after a deal closes, according to a study by S&P Global.

-24%: Amount by which stock returns of merged companies trail those of rival bidders three years after a deal closes, according to UC-Berkeley researchers.

A version of this article appears in the March 15, 2017 issue of Fortune with the headline “Stocks That Are Better Off Single.”