Value creation goes out of the door

The most talked about news in the tech industry today is Microsoft’s unsolicited offer to acquire Yahoo! which was first publicly announced in January 08. This weekend, after a roller coaster ride of hopes and expectations, Microsoft announced to walk away from the deal causing Yahoo!’s stock to plummet over 15% on Monday. Having closely followed the deal since the beginning, I find it hard to resist talking about how the market dynamics lead one to make completely irrational decisions. I am not going to argue whether the company is worth $31 a share, as I do not intend to speculate. I will also not argue if Microsoft would be willing to pay more and what the true opportunity costs are for Microsoft to walk away from the deal. But what I will talk about is why I believe that the market, at large, is behaving irrationally regardless of what Yahoo!’s stock is worth.

Several Yahoo! stockholders argue that a sweetened offer of $33 per share would have been good enough for them and Jerry Yang and Co. should have willingly accepted the offer and not let Microsoft walk away from the deal. Some investors feel so strongly about this that they have openly expressed their frustration with the Yahoo! board. Contrary to the management’s belief, investors and the public in general really believe that company is not worth $31 per share. And they also believe that Microsoft will not be willing to pay more. This is where academia deviates from real life. The fundamental concept of asymmetric information between the insiders and the shareholders goes out of the door. An average investor on the street seems to think that he knows the company’s business better than the management itself. And guess who influences the average investor’s decision about a stock? – Wall Street analysts, media and stock pundits who every so often know nothing more than any intelligent investor, but have a big audience nevertheless.

Well before Microsoft walked away from the deal, an analyst from a leading Wall Street firm published a report stating that the probability of Microsoft walking away from the deal was 10%. This analyst (if you are savvy enough to follow the deal closely, you know who I am talking about) calculated the target stock price for Yahoo! by assigning % to all likely scenarios in the deal and taking a weighted average of the possible outcomes. To me, there is only one phrase that best describes this mechanism of computing a stock’s value – “Garbage In Garbage Out”. These are the people whose public opinions have a significant impact on the movements in the market, and what they do is speculation at best. At least that’s what they have done in this case. The analyst speculated that it is only 10% likely that Microsoft will walk away from the deal. As we all know, Microsoft did walk away this weekend. How credible are these analyst projections that claim to know where the market is heading? The market, at large, is heavily driven by sentiment. An average unsophisticated investor has little clue about what the company is truly worth. All that really matters is what everyone else thinks the company is worth. And since everyone else uses the same approach, the market is grossly vulnerable to “group think”.

What short-term investors fail to understand, or do not care, is that the biggest merger in the tech industry since AOL-Time Warner, if that counts, is easier said than done. Hypothetically, if the two companies merge today, it would no doubt create a very formidable competitor to Google. However, Yahoo! and Microsoft have entirely different cultures and merging the two entities will be a logistical nightmare. Both companies have so many overlapping properties – Mail, Messenger, Search, Finance, Personals, Sports, Autos, News, MSN – the list goes on and on. Yes, there are enormous synergies to be exploited, but due to the laser-sharp execution required, 2 plus 2 could very well equal 3 in this deal. It is difficult, if not impossible, for anyone but the management to know if a merger would truly create value for shareholders.

I believe the only rational investors in the market are long term value investors that invest in companies not because they believe that a stock which is at $10 at opening will be at $15 by noon, but because the companies fundamentally create shareholder value in the long run. Arbitragers do not have a clue what “value creation” is. Unfortunately for Yahoo! and Microsoft, a significant proportion of the stock is held by mindless arbitragers who do not care about long-term value. The large institutional investors holding stock in these companies that do understand “value creation” care more about their own pay day.

And the bottom line is this – the market seems to want a deal to happen regardless of long-term implications. A deal may or may not be a good thing for the two companies depending on how well the companies are integrated, but the market does not care less. The greed of the ruthless market has eclipsed all rational behavior.