By Brian Nichols –
March 13, 2013

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Brian is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

Far too often retail investors hurry and buy a stock when whispers of an acquisition occur, but then return losses when the acquisition never materializes or when the buyout price is less than investors expect (i.e., Clearwire). Now, investors are looking to another high-profile company that is in the market to acquire, but the question remains, who will Yahoo (NASDAQ: YHOO) acquire and should investors chase the speculation?

What’s Going On?

Back on March 7, a Yahoo executive stated that the company is working on two “significant” acquisitions. Almost immediately shares of OpenTable (NASDAQ: OPEN) and Yelp (NYSE: YELP) responded to the rumors and traded higher. While mobile advertising company Millennial Media (NYSE: MM) did not trade higher, it was also at the center of speculation. Then, on Monday, shares of Zynga (NASDAQ: ZNGA) popped higher by 10% when Wunderlich’s Blake Harper said that he views Zynga as a potential buyout target.

Do you Want to Play Roulette?

Each of the four companies make sense as a potential acquisition for Yahoo! Zynga could strengthen the company’s social media exposure, and could be acquired relatively cheap compared to the valuations of some social media companies.

Millennial Media offers mobile advertising, and with mobile growing so rapidly, such an acquisition could be beneficial for a company that relies on revenue from advertising. Then, there are the food review sites Yelp and OpenTable, both of which would be a counter to Google’s recent acquisition of Zagat. It was reported that back in 2009 Yahoo actually made a $750 million offer to acquire Yelp, and that Yahoo also pitched bankers of OpenTable as early as last year, therefore both seem possible.

Right now, we have four companies and two potential acquisitions. If you consider a 50% chance of investing in two of the four then your chances of returning a large pop are about equal to that of choosing red or black at a roulette table. The problem is that social media expands every day, and when you consider the number of promising public companies, your chances of successfully purchasing prior to an acquisition is more like choosing a number on a roulette table. Basically, it’s a risky business.

Hold on Just a Minute

Those who might feel compelled to invest in any of these four companies on the possibility of a Yahoo acquisition also need to consider the likelihood of Yahoo looking at other companies. Consider the fact that CEO Marissa Mayer was at Google for 13 years, most of her career, and held a number of top leadership positions. Most recently, prior to taking the CEO position at Yahoo, she was the Vice President of Local, Maps, Location Services. Therefore, she was part of several big acquisitions, but strangely enough, only one of the larger acquisitions (over $100 million) was a public company. Click here to see notable Google acquisitions since 2005.

If we look at the acquisition habits of internet-based companies, most prefer acquisitions of private companies. The primary reason is because internet-based companies are very expensive to acquire because of market valuations. For example, OpenTable trades with a price/sales ratio of 8.88 and saw 15.6% sales growth its last quarter. Therefore, despite the fact that Yahoo could integrate the business on a much larger scale, and grow it faster, it would take many years to ever pay off. For example, if Yahoo acquired OpenTable for a 50% premium, around $2.1 billion, and could maintain top-line growth of 20%, and profit margins of 15%, it would take almost 15 years for the OpenTable acquisition to return a profit from net income. Then, you have to worry if the business model can sustain itself in the ever-changing social media space.

Bottom Line

A couple months ago, I had a book published, Taking Charge With Value Investing (McGraw-Hill, 2013), and my goal of writing the book was to use my specialty and to explore market psyche, and to explain how the market behaves and how to capitalize on illogical trends and outlooks to return gains. In the book I show that one of the greatest opportunities in the market is when acquisition rumors begin, because very rarely do they ever materialize or appreciate to the expected price. Therefore, the natural behavior of retail investors is to buy in hopes of quick gains, but shorting on acquisition rumors has been the best trade for the last five years.

I might add that I’m not saying none of the four companies above will be acquired. However, when it really comes down to it, companies and CEOs such as Yahoo and Marissa Mayer are smart, and realize the length of time that it takes for a high-profile internet-based acquisition to pay off in terms of profit. They also know that in social media, only a handful of companies will last longer than 15 years, and most companies learned from the dot-com debacle of 2000.

With that being said, I think it is very unwise to invest in one of the four companies above on the prospects of a potential acquisition. If you believe in the long-term fundamental prospects and believe one is priced attractively to the market, then invest. But more than likely, Yahoo will continue the trend of purchasing private companies, and there will be a number of investors upset with their lack of return, and their ultimate loss.