By George Huang

Ten years ago, hopeless investors chased Internet stocks hoping to cherry-pick the next takeout target, searching for an overnight triple-digit gain. They did it again with biotech in 2000 and again with oil stocks in 2007. They all lost money.

You see, most folks do the exact opposite of what they should be doing when it comes to speculating in mergers...

With thousands of possible acquisition targets, trying to guess the next takeout is a sucker's bet. And novice traders plow money into one buyout candidate after another, only to suffer a handful of 30%... 40%... or 50% losses when no suitors come knocking.

These folks don't know the real secret behind picking up free money from mergers: Big profits are banked AFTER the buyout announcement.

The strategy – known as "merger arbitrage" – is so simple and lucrative, an entire generation of hedge funds was created just to take advantage. The average merger-arbitrage fund returned about 12% per year for the last decade. Over that time, every dollar invested – even in a mediocre fund – translated into three bucks. (During the same period, every dollar invested in the overall stock market would've returned 95¢.)

The strategy is actually quite simple, despite its fancy Wall Street name. Let's examine the recent buyout of Anheuser-Busch (maker of Budweiser beer) by Belgium-based InBev to see how profitable this approach can be.

In July 2008, InBev announced its intention to pay $70 cash for every Anheuser-Busch (BUD) share. The market, confident the deal would go through, immediately sent BUD shares up to the $67 range. Since the $70 price tag was practically guaranteed, the gap (also known as the "spread") between the BUD stock price and the actual offer was small. Investors who bought BUD shares at $67 would book a profit of about 5% ($3 per share) after the deal closed.

You might scoff at a 5% return. But remember, the money is next to guaranteed. And the holding period is just four months. That means you could generate a 15% annualized return without any risk. Such a return trumps the miniscule 0.5% or so you fetch from a money-market fund.

But recent chaos in the financial markets offers us an unbelievable chance to milk this strategy for even higher returns. Here's why...

The financial turmoil that began last fall means the days of cheap credit are gone. Mergers that depend on heavy financing no longer look like shoo-ins. Suddenly, betting on deals closing seems dicey at best.

As a result, merger-arbitrage spreads, even on the safest deals, surpassed 10%, the widest in two decades. Here lies our opportunity...

Since buyout deals typically close in three to four months, a merger-arbitrage spread greater than 10% means we can make close to 50% per year, with next to no risk.

This scenario played out exactly with InBev's buyout of BUD...

BUD's stock plummeted from $67 in July to $55 in November, just three weeks before the deal was set to close. Despite repeated assurances from both companies, the credit crisis made the $70 buyout offer seemed far from "risk-free." No one wanted to touch BUD stock. But brave investors who bought at the time made more than 25% in just a few weeks (an annualized return of 300%) after the deal closed in December.

These days, spreads aren't quite that huge. But investors are still spooked, and there's plenty of money to be made. Two deals I'm watching are upcoming health care mergers: Pfizer-Wyeth and Merck-Schering.

Both mergers have a more than 95% chance of being completed in the next three months. Yet both Wyeth (WYE) and Schering-Plough (SGP) are trading about 7% below the respective offer prices. If you buy now, betting these deals close in a few months, you can make an annualized gain of more than 25%, with virtually no risk.

Good investing,

George Huang