Using Machine Learning to Analyze Merger Activity

Abstract

An unprecedented amount of access to data, “big data (or high dimensional data),” cloud computing, and innovative technology have increased applications of artificial intelligence in finance and numerous other industries. Machine learning is used in process automation, security, underwriting and credit scoring, algorithmic trading and robo-advisory. In fact, machine learning AI applications are purported to save banks an estimated $447 billion by 2023. Given the advantages that AI brings to finance, we focused on applying supervised machine learning to an investment problem. 10-K SEC filings are routinely used by investors to determine the worth and status of a company–Warren Buffett is frequently cited to read a 10-K a day. We sought to answer–“Can machine learning analyze more than thousands of companies and spot patterns? Can machine learning automate the process of human analysis in predicting whether a company is fit to merge? Can machine learning spot something that humans cannot?” In the advent of rising antitrust discussion of growing market concentrations and the concern for decrease in competition, we analyzed merger activity using text as a data set. Merger activity has been traditionally hard to predict in the past. We took advantage of the large amount of publicly available filings through the Securities Exchange Commission that give a comprehensive summary of a company, and used text, and an innovative way to analyze a company. In order to verify existing theory and measure harder to observe variables, we look to use a text document and examined a firm’s 10-K SEC filing. To minimize over-fitting, the L2 LASSO regularization technique is used. We came up with a model that has 85% accuracy compared to a 35% accuracy using the “bag-of-words” method to predict a company’s likelihood of merging from words alone on the same period’s test data set. These steps are the beginnings of tackling more complicated questions, such as “Which section or topic of words is the most predictive?” and “What is the difference between being acquired and acquiring?” Using product descriptions to characterize mergers further into horizontal and vertical mergers could eventually assist with the causal estimates that are of interest to economists. More importantly, using language and words to categorize companies could be useful in predicting counterfactual scenarios and answering policy questions, and could have different applications ranging from detecting fraud to better trading.