When rumors surfaced of Zillow’s (Z) acquisition of Trulia (TRLA), both stocks immediately jumped, with TRLA 12 points in a matter of minutes. With over a million shares of TRLA shorted, this was a significant problem for a lot of long/short funds, especially as both stocks were favorite targets for a number of reasons. Neither was profitable, both were in a messy industry with a low barrier to entry and high costs, and the nature of its supply—the U.S. housing market—was still recovering from one of the worst financial catastrophes in living memory. Combine that with huge stock price appreciation in 2013 and the beginning of a tech industry-based correction in 2014, and it becomes obvious why these stocks were on a lot of short lists.
And then on Thursday, those shorts were squeezed out or facing the threat of a squeeze, as news spread of the possible merger. With TRLA reaching a market cap of $1.8 billion, many in the market couldn’t help but wonder if the stock was already getting too expensive.
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At this point, many traders were expecting greater volatility, but it remains unclear whether the stock would end higher or lower than 52 when the merger was officially announced—if it was at all. This provided a real and common conundrum; has TRLA already become too pricey after its pop, and therefore should be a short or sell when the news is released?
To answer that question, we only need to know one thing: exactly how valuable is Trulia to Zillow. This is a very different question than how valuable is Trulia to a common stock holder. Investors look at P/E, revenue growth, market share, and market size to value stocks. Competitors gain much more value than that when buying a company; they can expand their own market share while also taking the market share of their competitor, they can reduce costs, thus expanding their operating margins, and they can have greater power within the marketplace more generally.
These are all intangibles, and very difficult to model. They’re more qualitative values, but they are tangible and absolutely a topic of conversation when competitors come to the table about a possible merger or acquisition.
This doesn’t mean it’s impossible to invest on that conversation, however. On Thursday afternoon and Friday, investors had the choice to try to identify the value of all of those intangibles and decide that, actually, the market was still pricing TRLA too low for its potential value to Z, even if the company is unprofitable, in a dubious market, and pinched for growth. While some investors took these aspects of the merger into consideration, many did not; they simply looked at the stock price, the market cap, and dismissed it as too expensive at $52 a share.
In most market conditions, this way of thinking about stocks is right. When a merger or acquisition is in the air, however, those rules go out the window. Instead of pricing the stock as the market would price it, you need to price it as the stock’s competitor would price it.
This is much harder to do, but those who did it with TRLA profited handsomely. On Monday, the stock opened at a 21% gain from Friday’s price point, and closed even higher, giving the investor plenty of time to take short-term gains.