John D. Leeth J. Rody Borg
Bentley College Jacksonville University

1. Introduction

Numerous studies examine the financial impact of mergers on shareholder wealth. All find target firm shareholders recording large gains but few uncover gains accruing to stockholders of acquiring firms. Equally puzzling, many studies show acquiring firm share prices falling for up to three years after consolidation, a result largely inconsistent with expectations that mergers raise profitability.

Some economists claim the existing economic and legislative environment prevents acquiring firm shareholders from earning large takeover gains. For instance, current antitrust enforcement may reduce acquisition profits by inhibiting mergers between firms producing related products which would likely generate large collusive and operational synergies. Additionally, national and state laws regulating takeovers, most notably the 1968 Williams Act, and sophisticated defensive tactics by targets may also lower acquisition profits by slanting merger gains from acquiring to target firm shareholders. Likewise, growth in the number of contested bids for control and innovations in acquisition financing indicate an increasingly competitive market for corporate control, again skewing gains toward target firm shareholders.

Our research examines the impact of mergers from 1905 to 1930 on acquiring firm shareholder wealth to determine if early industrial acquisitions in the United States benefited firm owners. Throughout the period, technological and managerial changes were rapidly advancing industrial production. Antitrust laws existed but Justice department enforcement was lax, especially following adverse court rulings in 1918 and 1920. Congress did not pass legislation protecting stockholders from stock manipulators, raiders, or unscrupulous managers until well after the 1929 stock market crash. The Securities and Exchange Commission did not exist and, until enactment of the Celler-Kefauver Act in 1950, the Federal Trade Commission had little power to regulate mergers. Unlike today, mergers from 1905 to 1930 were mainly horizontal.

Large synergistic or monopolistic gains anticipated from early consolidations, combined with minimal stock market regulation and reduced competition for corporate control should allow acquiring companies to capture large takeover profits. Chandler (1977) argues mergers before World War I were, in fact, highly profitable when managers moved quickly from a strategy of horizontal combination to one of vertical integration. Still, one may question whether or not investors reacted positively to the arrival of the large-scale industrial organization and the resulting separation of ownership from control given the impact of this movement on railroad securities in the 1880s. As described by Chandler, manager inspired over-building generally lowered railroad profits and frequently forced companies into reorganizations, reducing or destroying share value.

To investigate the success of mergers from 1905 to 1930 we apply the same general approach used to determine the stock market success of current acquisitions. We collect financial data on a broad portfolio of acquiring firm stock and compare the returns on the portfolio relative to expectations based on previous earnings and stock returns in general. Unlike other historical studies, we examine a merger sample spanning a broad period and determine the stock price impact of both the first news report of a merger and its completion. In an efficient market, stock price changes at announcement fully capture the market's assessment of a merger. Although the resolution of uncertainty about the terms of the merger will cause individual stock prices to change, on average the gains and losses should roughly cancel in a large portfolio of acquisitions spread over time. Relying on completion dates, the one previous financial investigation of historical mergers fails to pinpoint the date best reflecting merger gains, thus explaining the low and fragile statistical significance of the results. Brown and Warner (1980) demonstrate the difficulty of observing abnormal stock price performance with event date uncertainty; and almost all financial studies measure takeover gains at announcement.

The 26 year time frame also allows us to examine the importance of economic environment, antitrust enforcement, and general level of takeover activity on merger gains by comparing the success of acquisitions before and after 1919. Economic historians point to revolutionary changes in the structure and management of industrial production beginning shortly before the turn of the century and ending with World War I. Embodying the economic environment, mergers before 1919 were largely between single-function firms which later moved into all stages of production and distribution, while mergers after 1919 were typically between fully integrated enterprises. Antitrust enforcement also became more lenient after 1919 as repeated Justice Department losses in court all but stopped the control of business consolidations for more than a decade. More importantly, 1919 represents the beginning of the oligopoly merger wave which continued until the onset of the Great Depression in 1930. Relative to the size of the economy, the surge of business consolidations during the 1920s far exceeds the surge of activity in the late 1960s and early 1980s.

Mueller (1989) contends managers and investors overestimate consolidation gains during peak periods of merger activity, explaining the tremendous loss in share value after completion frequently observed in contemporary studies heavily weighted with acquisitions from the two post-World War II merger waves. Similar to a stock market bubble, managers and investors get caught up in the frenzy, believing each new acquisition will be better than the last. Marginal acquisitions skyrocket, yet the market continues to react positively to merger news. The bubble bursts when actual post-merger performance forces investors to reevaluate acquisition success. If Mueller's contention is correct, then the decrease in acquiring firm stock price frequently observed after merger completion should be greater during the 1920s merger wave than during the years of relatively infrequent merger activity from 1905 to 1918.

Examining a portfolio of 191 firms, about 11 percent of the total number of acquisitions from 1905 to 1930, we find mergers raise acquiring firm shareholder wealth on average from 4 to 7 percent; an increase which exceeds shareholder gains from more recent acquisitions. We discover only minor differences in the pre-completion performance of mergers before and after 1919, but substantial differences in the post-completion performance. Acquiring firm shareholder wealth in the 1920s fell 13 percent the year after takeover, while shareholder wealth from 1905 to 1918 rose moderately. Consistent with Mueller's belief, investors during the second merger wave anticipated profits but reevaluated the prospects for gain as additional information became available. No post reevaluation occurred from 1905 to 1918, a period of limited merger activity.

2. Data and Empirical Method

The starting point of our research is Ralph Nelson's list of 1,742 completed acquisitions from 1905 to 1930. From his list, we include in our data set any company with published stock price data, a complete record of cash and stock dividends, and an absence of merger activity for 36 months prior to the acquisition under study. The first two criteria slant the study toward larger and relatively well-documented companies, while the third allows us to estimate more accurately each firm's relative stock-market risk. The exclusion of frequent acquirers also gears our investigation towards mergers representing relative surprises to the financial community, thereby increasing the likelihood that our measures of stock returns closely reflect the economic value of the takeover to acquiring firm shareholders.

Based on information from The Commercial and Financial Chronicle and Moody's, we generate monthly holding period returns over eight years adjusting for cash and stock dividends and stock splits. We control for movements in stock returns unrelated to acquisitions using standard event-study methods. Specifically, we define abnormal return for stock i in month t as 

where Rit is the stock's realized return for month t and E(Rit) is its expected return in the absence of a merger. We reference time relative to: (1) the month the merger is first announced in the financial press and (2) the month the acquiring firm obtained legal control of the target firm's assets.

We calculate E(Rit) using three procedures. The first two express expected return as a simple linear function of market return, Rmt. Specifically, E(Rit) = ai + §iRmt. The simple market adjustment sets a equal to 0 and § equal to 1 for all stocks, while the market model adjustment varies a and § values across stocks. In the third procedure, based on the Capital Asset Pricing Model (CAPM), expected return equals the risk-free interest rate, Rft, plus a risk premium. Algebraically, E(Rit) = Rft + §i(Rmt - Rft). Similar to the market model, the CAPM adjustment varies § values across stocks. We determine a and § coefficients by regressing each stock's monthly return against the return on stocks in general using data from 60 months before to 13 months before the merger announcement.

Financial economists frequently measure the impact of a merger by cumulating a stock's abnormal returns from some date before the initial report in the financial press to some date after completion. Because portfolio diversification eliminates abnormal performance caused by events unrelated to a merger, they also generally group acquiring firms into a single portfolio and measure the performance of this portfolio over time. Following this procedure, we define average cumulative abnormal return from t=J to t=K as 

where N represents the number of firms in the merger portfolio. By controlling both for general movements in stock prices and movements unrelated to acquisitions, equation (2) represents the basic measure of merger success, the average percentage increase in shareholder wealth. If consolidations allow acquiring firms to capture economies of scale or scope or earn monopoly rents, then the higher expected profit will cause investors to bid up the price of stock producing a positive average cumulative abnormal return. However, if the separation of ownership from control allows managers to pursue unprofitable acquisitions or the winners' curse causes managers to overpay for target firm assets, then the lower expected profit will cause investors to offer less for acquiring firm stock, producing a negative average cumulative abnormal return.

3. Merger Gains

To determine the financial impact of mergers on acquiring firm shareholder wealth, we should examine abnormal returns over the period beginning when investors first learn of an impending acquisition and ending when they finally receive all pertinent details about its likely success. Financial economists typically use a very short cumulation period, often measuring the share-price impact over a two to three day span beginning shortly before the formal press announcement. On the other side, some industrial organization economists argue for an extremely long cumulation period contending the financial community learns of an impending acquisition months before the initial press report and continues to receive information about the probable success of the merger years after the takeover. The absence of broad stock market regulations and insider trading prohibitions from 1905 to 1930 increases the likelihood investors learn of upcoming mergers months before public announcement.

Even today, when trading on insider information is illegal, financial studies often show stock prices rising before announcement. Because the dramatic increase in target firm share value makes the actual onset of merger related information quite apparent, Magenheim and Mueller (1988) argue researchers should begin measuring gains or losses on acquiring firm stock when target firm share prices start to increase. Using this standard, they claim the market first learns of approaching mergers about 3 months before the first press release. In preliminary work, we examine the stock price performance of 43 firms acquired from 1919 to 1930 and discover the same upward trend 3 months before the announcement month.

The results of our own work on 1920s targets and numerous contemporary studies indicate an accurate measure of the market's evaluation of anticipated acquisition profitability starts three months before announcement and continues through completion. Over this period, we find mergers from 1905 to 1930 significantly raising acquiring firm shareholder wealth with measures of average abnormal returns ranging from 3.81 to 7.57 percent. In short, with the information available before completion, investors anticipated mergers successfully increasing acquiring firm profitability.

Some suggest the current highly competitive and regulated market for corporate control reduces acquisition profitability by slanting gains from acquiring firm to target firm stockholders. In particular, they argue changes beginning in the late 1960s such as the passage of state and national laws regulating takeovers, the introduction of sophisticated anti-takeover strategies, and the expanded frequency of multiple bidders explain the secular decline in the returns from acquisitions through tender offers from 5 percent in the 1960s to zero in the 1980s. No one documents a comparable decline in the profitability of acquisitions requiring a vote of target firm shareholders; gains were essentially zero even before 1980. Consistent with the belief that regulation and competition reduce acquisition profitability, takeover returns from 1905 to 1930 significantly exceed recent returns from either tender offers or acquisitions requiring shareholder approval and, by most measures, tender offer gains in the 1960s.

4. Post-Merger Losses

Similar to contemporary acquisitions, the post-completion performance of acquiring firm stock from 1905 to 1930 challenges the view mergers create shareholder value. On average, the year after completion, acquiring firms lose more than 6 percent relative to stocks in general and CAPM expectations and more than 12 percent relative to market model projections.

To determine if pace of production and management development, antitrust enforcement, or merger activity affect takeover profitability or post-merger performance, we compare abnormal returns from acquisitions before and after 1919. This year represents the end of the managerial revolution, the beginning of eased antitrust enforcement, and most importantly, the start of the oligopoly merger wave. Our results provide no evidence of differences in pre-completion returns between the two time periods but do indicate substantial differences in post-merger performance. Acquiring firms from 1905 to 1918 earn abnormal returns of 7.90 percent the year after completion while acquiring firms from 1919 to 1930 lose 13.55 percent. Although large portfolios of acquiring firm stock should earn neither abnormal gains nor losses after completion, over short time periods institutional or economic changes common to all acquiring firms can produce large abnormal gains or losses on average even if prices efficiently incorporate all available information at announcement. Over the period best reflecting merger gains, pre-1919 acquisitions raise shareholder wealth by 6.88 percent. Magenheim and Mueller argue investors continue to evaluate merger success for up to three years after completion. Using this standard, acquisitions benefit shareholders by another 36.81 percent. Regardless of which months to include, investors from 1905 to 1918 believe acquisitions will be profitable; a belief consistent with the actual ex-post stock market performance of the firm.

Takeovers during the 1920s fail to create a permanent increase in shareholder wealth. Impending acquisitions raise stock price by essentially the same amount as acquisitions in the early period but the year after consolidation shareholder wealth falls dramatically. Investors purchasing acquiring firm stock three months before any public announcement and holding until consolidation earn abnormal returns of 7.12 percent, but then lose 13.55 percent the following year. Post-consolidation losses eliminate the small pre-acquisition gains.

Chandler refers to the period from 1905 to 1918 as the completion of the managerial revolution. This revolution created the modern corporation, integrating mass production with mass distribution and separating ownership from control. Our results demonstrate the remarkable success of mergers during the highly dynamic period before 1919. Not only do pre-merger prices rise by almost 7 percent, but also post-merger prices continue to rise reflecting firm profitability. The pace of industrial and managerial change slows in the 1920s but merger activity rapidly expands and antitrust enforcement eases. Our results provide a mixed review of 1920s mergers with stock price rises followed by even larger declines.

Financial economists studying more contemporary takeovers frequently discover negative post-consolidation performance. By relying on samples drawn heavily from the late 1960s to the early 1980s, they essentially examine mergers occurring during peak years of merger activity. Mueller contends overoptimism creates both merger waves and more severe problems with the winners' curse, the general overpayment for target firm assets. After consolidation shareholders reevaluate the prospects for gain and share price falls. Our results support Mueller's belief that merger waves fuel unprofitable mergers and post-acquisition losses. During the non-peak merger years before 1919, acquisitions permanently raise shareholder wealth, while during the 1920s merger wave shareholder wealth temporarily rises based on pre-acquisition expectations but then falls dramatically, perhaps as reality sets in after consolidation.

5. Conclusions

Successful acquisitions should increase firm profitability and stock price. Even on this limited basis, economists hotly debate the merits of industrial consolidations. In the two assessments of mergers near the turn of the century, Dewing (1921) concludes consolidations largely fail to raise profits or meet pre-merger expectations, while Livermore (1935) concludes acquisitions generally create highly profitable firms. Even today financial economists usually contend takeovers create value by sharply raising target firm stock price, while industrial organization economists typically argue takeovers reduce value by lowering ex-post profits of acquiring firms. Financial economists do not explain why contemporary mergers fail to increase acquiring firm shareholder wealth or why acquiring firm stock price tends to fall after completion.

We examine the impact of mergers from 1905 to 1930 on acquiring firm shareholder wealth to determine if early industrial acquisitions benefited firm owners. Technological and managerial advancements dramatically transformed industrial production in the United States throughout the period. Antitrust enforcement was weak and the Securities and Exchange Commission did not exist. No law required a firm to issue a prospectus before selling new securities to the public or prevented it from acquiring a target by secretly purchasing a majority of stock in the open market. Individuals could legally trade on insider information.

The existence of perhaps larger synergistic or monopolistic gains from consolidation, the absence of stock market regulation, and the lower competition for control should allow acquiring companies to capture large takeover profits. In fact, acquiring firm shareholder wealth from 1905 to 1930 increases dramatically before consolidation, rising by 4 to 7 percent; however, consistent with the belief that managers and investors unrealistically evaluate consolidation gains during merger waves, acquiring firm stock price drops by more than 13 percent the year after consolidation in the 1920s. In contrast, during the non-peak merger years from 1905 to 1918 acquiring firm stock price rises another 8 percent the year after consolidation.

The period from 1905 to World War I represents the completion of the managerial revolution in the United States. Mergers before World War I were largely between single-function firms that eventually moved into production and distribution, while mergers after World War I were between fully integrated enterprises. Our results indicate consolidations were highly profitable for acquiring firm owners from 1905 to 1918 but unprofitable from 1919 to 1930. During both periods investors anticipated merger gains before takeover, but during the 1920s investors apparently reassessed potential profits after completion, driving stock price down and causing post-merger losses to swamp pre-merger gains.