Bet on Takeover Targets: 3 Spicy Picks - Investment Ideas

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You must have noticed stocks soaring instantly on takeover bids by mega players. But you might not have been able to predict takeover targets and hence missed lucrative opportunities.   

Wouldn't it be nice if you could spot the market's next takeover target before corporate raiders zero-in on it? The M&A landscape for 2014 looks bright with huge cash sitting on corporate balance sheets, favorable credit markets, low interest rates, and strength in stock market, making this the ideal time for hunting such stocks.

This is a tall order, but not out of the question. There is no full-proof strategy to find a company that would surely get a tender offer to be acquired, as it's not all about numbers. A suitor looks for a number of fundamental characteristics - such as product niche, distribution network, geographic proximity, litigation risk and management - in the acquiree. These are basically the deal's cultural/strategic value that may evade your analytical eyes.   

But you can shortlist companies with high chances of getting a bid. For that you need to peruse a few ratios/numbers that corporate raiders must consider to strike a deal. These are no doubt good indicators, but not sufficient to ensure a takeover.

Actually, had it been that easy to look through the lens of a suitor, the market would have made prospective acquisition targets instantly overpriced, leaving no room for you to make a sudden gain. In fact, it is this unpredictable nature that keeps the appeal alive.             

To me, it's a chance game. Buying a stock solely for the potential takeover gain may not be a prudent decision. After all, you never know if the corporate raiders are on the same page. But you can use the right strategy to increase your odds of winning.

The Win-Win Strategy

In addition to using similar valuation techniques as corporate raiders, I recommend tracking stocks with the right ingredients to outperform. That way, even if your selected stocks fail to attract takeover bids, they will not disappoint you in terms of price appreciation. And always the chance of a takeover gain will be high for each of these stocks.

Here I have discussed the method and created a screen (using Research Wizard ) that you can run to have your cake and eat it too!      

What an Acquirer Needs to Pay Matters Most

What an acquirer has to roughly shell out to buy an entire company is the Enterprise Value (EV) of the latter. Here is the formula:

EV = Market Capitalization + Long-term Debt + Book Value of Preferred Stock - Cash and Marketable Securities  

An acquirer will always prefer to pay as low as possible, but a nominal number doesn't necessarily indicate inexpensiveness. For that, measuring the EV relative to its ability to generate profits - Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) - is of utmost important to the acquirer.

A low EV/EBITDA ratio indicates larger profit generating ability relative to its worth. The smaller the ratio, the more attractive the target.

Screening Criterion: EV/EBITDA Range > 0 and <1

Cash Has a Solid Appeal

Companies that are sitting on a cash pile are darlings of corporate raiders, as it reduces the cost of buying. But looking at cash is not that simple; a high number doesn't necessarily indicate affluence. So cash as percentage of market cap is the key to finding cash-rich bargains.

I searched companies with cash and marketable securities of at least 75% of their market capitalization. These companies offer significant discount to acquirers.

Moreover, from an investor's perspective, buying stocks of these companies will channel less than 25% of the investment to their ongoing business -- the risky part.

Screening Criterion: (Cash and Marketable Securities/Market Capitalization) >= 0.75

Low Financial Leverage Enticing

Companies that depend less on external borrowings for capital expenditures are attractive to acquirers. This is because acquiring it doesn't add much debt load on the acquirer's balance sheet. So I selected companies with debt less than equity.  

Screening Criterion: (Debt/Equity) < 1

Underpriced Stocks Preferred

Book value is a rough estimate of what equity holders tangibly own in a company. Stocks trading at a low price-to-book ratio are always assumed as cheaper. These stocks have a greater possibility of getting acquisition bids.

Screening Criterion: (Price/Book Value) <= 1.5  

Bet Big on Small-Cap Stocks

First of all, affordability matters. The lesser the company's market capitalization, the more its prospective buyers. If you look back at the last few years, the majority of acquirers picked small-cap stocks.     

Secondly, the market hypothesis is not that efficient for small-cap stocks as these are often ignored by analysts. Lack of market insight keeps these stocks mispriced, which creates opportunity for prospective acquirers to exercise a lucrative deal.   

That is why the possibility of small-cap stocks getting acquired is higher that that of the mega-cap stocks.

Screening Criterion: Market Capitalization Range > $50 million and < $2 billion

Ensure Favorable Zacks Rank   

Good market or bad, stocks with a Zacks Rank #1 (Strong Buy) or #2 (Buy) generally outperform. Stocks with these ratings have been actually witnessing positive earnings estimate revisions, which should ultimately translate into price appreciation.

This should actually ensure a return even if your selected stocks do not offer a takeover gain. So lock your choice with these ratings which have a proven history of success.

(See the performance of Zacks' portfolios and strategies here: About Zacks Performance ).

Screening Criterion: Zacks Rank <= 2

How Successful Is the Strategy?    

I backtested this screen with a 4-week holding period over the last 5 years to see whether the group of stocks matching these parameters had at least returned better than the S&P 500. I found a promising result, as you can see here:



3 Potential Takeover Targets

Before adding the Zacks Rank criterion, the screen actually gave me 15 stocks, all of which should catch eyes of corporate raiders. But if they fail to do so, the ones with favorable Zacks Rank should not disappoint.

So I reran the full screen to find those that have favorable Zacks Rank too. Here are the 3 stocks that finally got through:

Central Valley Community Bancorp ( CVCY ): Headquartered in Fresno, CA, this Zacks Rank #1 pacific bank provides various commercial banking services to small and medium-sized businesses, individuals, and professional communities.

EV/EBITDA = 0.84
Cash and Marketable Securities/Market Cap. = 0.91
Debt/Equity = 0.04
Price/Book Value = 1.02
Market Cap. ($million) = 123

Fidelity & Guaranty Life ( FGL ): This primary life insurance and fixed annuity company is based in Des Moines, Iowa and primarily serves the middle-income market. It holds a Zacks Rank #2.

EV/EBITDA = 0.76
Cash and Marketable Securities/Market Cap. = 0.81
Debt/Equity = 0.23
Price/Book Value = 0.95
Market Cap. ($million) = 1,306

Genco Shipping & Trading Ltd. ( GNK ): This Zacks Rank #2 company is based in NY and engages in ocean transportation of drybulk cargoes worldwide.

EV/EBITDA = 0.96
Cash and Marketable Securities/Market Cap. = 1.59
Debt/Equity = 0.10
Price/Book Value = 0.06
Market Cap. ($million) = 75

Note: All data are as of Mar 28, 2014

Don't Gamble, Play It Safe

This screen is just the starting point for your due diligence. Don't bet on a stock just because it has favorable numbers to get acquired. You should also see if it suits your investment goals and risk tolerance.

Pull the trigger if you anticipate a good return even if it doesn't get a takeover bid. The takeover potential may add a handsome bonus to your return. However, the market reacts briskly, so the faster you take action, the more you gain.

So what are you waiting for? Get started!  

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Disclosure: The author has no positions in any stocks mentioned.

CENTRAL VLY COM (CVCY): Free Stock Analysis Report

FIDELITY&GUARNT (FGL): Free Stock Analysis Report

GENCO SHPG&TRDG (GNK): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks

Referenced Stocks: EV , CVCY , FGL , GNK

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