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. A month after the announcement of the deal, ABC Tech’s stock is likely to be trading at $60-$65, some 20%-30% higher than the pre-takeover price.
As you might expect, such profitable plays have been hard to find ever since the stock market swooned in 2008. According to Bloomberg, M&A activity in the U.S. dropped by about 50% from 2008 to 2009, falling to 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 recently? A somewhat healthier economy and a stronger stock market builds confidence among prospective acquirers. At the same time, stocks remain far below their peak prices so buyers can find possible bargains. Perhaps most important, as a recent Goldman Sachs report put it, “Companies accumulated historically high cash balances over the past twelve months as they sought stability in face of an uncertain macroeconomic environment. Cash-rich balance sheets are ripe for use.â€
Among those uses, big-fish companies may use their cash to feed on tasty littler 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. “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 outstanding shares. For perspective, Apple has a market cap over $175 billion.)“You also should 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, who is 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.
Ellis has identified a handful of stocks to watch, companies he believes could attract acquirers:
Blue Coat Systems (NASDAQ: BCSI), which provides systems to protect corporate IT networks from viruses
Websense (NASDAQ: WBSN), which offers Internet security to businesses
Epicor Software (NASDAQ: EPIC), whose products help businesses with enterprise resource planning and customer relationship management
Radiant Systems (NASDAQ: RADS), which specializes in hardware and software for hospitals and retailers
Diodes (NASDAQ: DIOD), a manufacturer of semiconductor components
“Blue Coat might be a good fit for a very large tech company such as Micrsoft or Oracle,†Ellis says. “The same might be true for Diodes, where net income is down while revenues are up. It seems like the company is ramping up its marketing efforts so it has had to spend more in that area. Diodes has a clean balance sheet, with a lot of current assets.â€
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.
WEALTH FOR LIFE PRINCIPLES
1. I Will Live Within My Means
2. I Will Maximize My Income Potential Through Education and Training
3. I Will Effectively Manage My Budget, Credit, Debt, and Tax Obligations
4. I Will Save At Least 10% of My Income
5. I Will Use Homeownership as a Foundation For Building Wealth
6. I Will Devise An Investment Plan For My Retirement Needs And Childrens’ Education
7. I Will Ensure That My Entire Family Adheres To Sensible Money Management Principles
8. I Will Support the Creation and Growth of Minority-Owned Businesses
9. I Will Guarantee My Wealth Is Passed On To Future Generations Through Proper Insurance And Estate Planning
10. I Will Strengthen My Community Through Philanthropy