Taking Advantage of Takeovers

When stocks rise, corporate takeovers usually aren’t far behind. Those takeovers can generate profits for investors–if you happen to own stock in the company being acquired.

In recent years, investors have reaped gains of roughly 25% when they own a merged or acquired stock. Here’s how it works: Suppose you own ABC Tech Co., now trading at $50 a share. Say XYZ Computer Corp. decides to take it over. In order to entice ABC Tech shareholders into approving the deal and selling their shares, XYZ must pay a premium to the current trading price. As a result of the announcement, ABC Tech’s stock is likely to be trading at $60 to $65, some 20% to 30% higher than the pre-takeover price.

As you might expect, such profitable plays have been hard to find ever since the stock market stumbled in 2008. According to Bloomberg L.P., M&A activity in the U.S. dropped by about 50% from 2008 to 2009, reaching its slowest pace since 2003. Toward year-end 2009, though, merger activity picked up. Takeovers involving U.S. companies rose from $26.6 billion in August to $49.1 billion in September.

Why the increased activity? A somewhat healthier economy and a stronger stock market build confidence among prospective acquirers. At the same time, stocks remain far below their

peak prices, so buyers may find bargains. Perhaps most important, as a recent Goldman Sachs report put it, “Companies accumulated historically high cash balances over the past 12 months as they sought stability in face of an uncertain macroeconomic environment. Cash-rich balance sheets are ripe for use.”

Among those uses, big-fish companies may use their cash to feed on tasty smaller fish. “There are only so many things companies can do with cash,” says Seth Ellis, co-founder of RWE Private Wealth, a financial advisory firm in Orlando, Florida. “They can pay dividends to shareholders, invest internally, or purchase other companies. Recently, nonfinancial companies were holding around 5%

of their assets in cash, which is extremely high by historic standards. A lot of that cash probably will be used for acquisitions.” The best acquisition targets, according to Ellis, can be found among companies with market capitalization of $250 million to $2.5 billion. In that size range, they’re big enough to be worth buying but small enough to make an acquisition practical. (Market capitalization is found by multiplying a company’s stock price by the number of its outstanding shares. For perspective, Apple has a market cap of more than $175 billion.)

“You should also look for companies with clean balance sheets and good operating prospects,” says Ellis.

“There has to be something that makes them attractive besides the low stock price.” Ellis, also a partner at Gator Mezzanine Fund, which makes loans to growing Florida companies, says the top M&A opportunities may be in the technology area because acquirers don’t have to buy a lot of outdated “bricks and mortar,” such as obsolete manufacturing plants.

From March 2009 until late in the year, U.S. stocks had their best short-term run in 70 years. If stocks continue to soar, investors who choose well-priced small- and medium-sized companies may reap a buyout bonanza.

This article originally appeared in the February 2010 issue of Black Enterprise magazine.